Are ESG Alpha and Beta Benefits in Corporate Bonds a Mirage?

In this new research paper, members of the quantitative research and portfolio management teams at Coolabah Capital Investments (CCI) present new evidence on whether the claimed alpha and beta benefits of ESG filters in both the global equities and corporate bond markets exist. You can download a full copy of the 10 page paper here or here, or review the executive summary enclosed below.

Executive Summary

A recent trend amongst retail and institutional investors has been the desire to construct portfolios that are compliant on an environmental, social and governance (ESG) basis. But this begs the question as to whether ESG factors have any relationship with future risk and return. Put differently, can ESG drive alpha and/or reduce beta? While there is a growing literature on the value of ESG factors (see Bektic (2017)), this paper presents alternative out-of-sample methods for isolating these relationships and considers both equities and corporate bonds in a global context.

Leveraging off one of the world’s leading ESG score providers available via Bloomberg, we initially find that ESG factors are not statistically significant in linearly predicting future equity alpha after controlling for market and industry betas on an out-of-sample basis for companies based in Australia, the US, Europe and Japan.

Our research is subsequently expanded to investigate non-linear relationships between ESG factors and future performance by examining quintile-based portfolios using the Capital Asset Pricing Model (CAPM) framework. Adopting this approach, we find that the best and worst ranked quintile portfolios on their ESG scores were statistically significant in generating alpha and reducing beta, out-of-sample, for companies in Australia and the US, but not for those located in Europe and Japan. Within the ESG scores, we found that the “governance” factor is by far the best predictor of future returns and risk, in Australia, the US and Europe.

In Section 3 we study the relationship between ESG factors and future corporate bond performance, focussing on the US market where the best available TRACE data exists. Employing a similar quintile-based portfolio and CAPM method, we find no statistically significant effects on alpha (in the CAPM sense), but ostensibly statistically significant beta reduction benefits.

Importantly, however, we demonstrate that better (worse) ESG scores are associated with superior (inferior) credit ratings, which is known to decrease (increase) beta.

In order to investigate the marginal effect of ESG scores, we construct quintile-based portfolios with similar characteristics along the three major dimensions that affect a bond’s risk and return profile, namely its credit rating, the issuer’s industry and the time to maturity (or call). After equalising the industry, tenor and rating composition of the five portfolios, we find that ESG factors do not significantly contribute to positive alpha in the bond market. In fact, the best social quintile portfolio has statistically significant negative alpha; though given the non-monotonicity of the results and the multiple applications of confidence interval tests without multiplicity adjustments, we cannot conclude in favour or detriment to ESG effects on alpha.

More importantly, however, once we adjust for credit rating and industry factors, we find that the previously observed beta-reduction benefits of ESG factors are no longer significant. In fact, the best environment and social quintiles have significantly higher beta, which is undesirable. In addition, better total ESG quintiles have betas that are nearly monotonically increasing and almost significant, which is again, undesirable.

We conclude that there is value in analysing ESG factors when considering individual investments in equities but less so in corporate bonds. There is a case for ESG alpha and beta benefits in the equity markets in Australia and the US, with governance by far the most important factor. We could not identify any objective ESG alpha or beta benefits in the corporate bond market, with ESG insights apparently already captured in companies’ individual credit ratings.

While ESG factor analysis is an important part of any investment process, participants need to understand the strengths and weaknesses of ESG scores.