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Federated Hermes – Pricing ESG risks in credit markets: Through volatility, our conviction confirmed

7 Jul 2021

Mitch Reznick, CFA is head of research and sustainable fixed income at the international business of Federated Hermes, while
Dr Michael Viehs is head of ESG integration and Tarandeep Panesar is senior performance analyst.

Back in 2017 we analysed the link between ESG factors and credit spreads1 in an effort to refine our ability as fixed income investors to more accurately price factors beyond traditional operating and financial risks. We were able to demonstrate that companies with better environmental, social and governance (ESG) practices tended to have lower credit default swap (CDS) spreads, even after controlling for credit ratings and other risk factors. Using the results, we plotted predictions of CDS spreads for given values of ESG scores, drawing an innovative implied ESG pric- ing curve. In 2018 we published an updated study 2 with a longer sample period which produced similar results.

We have recently completed a third study, expanding the sample period to include the period from the start of 2012 to the end of a volatile 2020. We found that the significant relationship between ESG factors and CDS spreads persists: companies with better ESG practices tend to have lower CDS spreads, even after controlling for credit risks. Secondly, the explanatory power of the model increased from the 2017 and 2018 studies. And finally, high levels of market volatility throughout 2020 did not significantly affect this relationship (a closer investiga- tion of the relationship within 2020 is, however, warranted).

The relationship reconfirmed

Our latest research shows that even when controlling for operating and financial risks (measured by credit ratings), as ESG factors deteriorate, credit spreads widen. Because the reverse is also true, this relationship has very important investment implications.

Our results suggest that credit markets are likely to reward companies that make the transition from ESG laggards to leaders with tighter CDS spreads. This observation is particularly poignant given that asset owners and fund managers are increasingly looking to ‘screen in’ companies seen as ESG and sustainability leaders to reinforce the ESG credentials of their portfolios. In this environment, companies with credible transition stories represent an excellent investment opportunity as they join the elite sustainable leaders of their industries. Moreover, according to our credit analysts and engagement specialists, the desire by companies them- selves to be ‘screened in’ explains much of their acceptance of sustainability.

Once, twice, three times you’ve swayed me

Having completed this third review, we are encouraged that our pricing model for ESG factors not only remains robust, but its explanatory power has actually increased. What’s more, the model has performed effectively through one of the most volatile periods ever in credit markets. This makes us confident that when we use the model in credit committees it is providing that additional precision that we seek.

Manage transition risk, but buy transition opportunity

The investment implications of the market’s ability to differentiate between low ESG quality and high ESG quality creates real opportunities. While it is important to control for operating and financial risks, we believe buying into credible transition stories can deliver alpha – whilst also ben- efiting society – as the market recognises an improving ESG story.

Our own investors have increased their scrutiny of sustainability credentials, whether mainstream or thematic (e.g. Sustainable Development Goals; climate change). Given the rising interest in ESG throughout the investment industry and the surge in sustainability-themed funds and strategies, we see rising demand for the so-called ESG leaders. Demand for sustainability-themed bonds in the pri- mary market is often stronger than for mainstream bonds, suggesting investors are pining for ESG leaders to strengthen the underlying sustainability credentials of their portfolios.

With this in mind, we believe buying credible transition stories will deliver alpha as they evolve into leaders and become ‘screened-in’. Our ESG pricing model shows that our investors will be rewarded for identifying these transition opportunities.

You can read the full research paper and in-depth analysis, research and commentary on sustainability direct from our investment teams at https://sustainability. hermes-investment.com/uk/en/intermediary/

1) Credit-ESG-Paper-April-2017.pdf (hermes-investment.com)

2) Hermes – Pricing ESG risk in credit markets: reinforcing our conviction (hermes-investment.com)

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