Analysis by Hermes Investment Management has revealed a “significant” correlation between ESG scores and CDS spreads, which it describes an important step in pricing environmental, social and governance risks in corporate debt.
The white paper, Pricing ESG risks in credit markets, uses Hermes in-house “Quantitative ESG score” to complete the analysis – a single number on a scale from one to five.
On average, the research found the companies with the highest ESG scores had the lowest CDS spreads.
The credit team will not invest in companies with the lowest score of five and will not hold overweight positions in the next lowest score of four, although they might hold it for risk management purposes.
Co-head of credit at Hermes Mitch Reznick says there had been little done in terms of trying to distil ESG risks from credit risk and the analysis represents the first time a clear relationship has been established between ESG and credit performance.
Average annual CDS spreads by quintile (2012-2016)
Source: Hermes calculations as at February 2017. Data sourced from Hermes Global Equities and Bloomberg. Corrected for outliers.
“What we’ve come up with is not a panacea in that it’s not an exact pricing model, but we think it’s a great place to begin understanding the marginal price or cost of ESG risk,” Reznick says.
CDS rather than bond spreads were used because they lack distortions from duration and are therefore the simplest reflection of risk premia, Reznick says. The research covered the five years from 2012 to 2016 in order to avoid noise from the financial crisis.
Among outliers that have strong ESG scores with wide spreads are Frontier Communications, Telefonica and L Brands.
In contrast, Reznick notes there are a lot of US media companies with governance problems that have low ESG scores but tight spreads, such as Fox and CBS. Walmart is another outlier with a low ESG score but tight spreads.
Reznick says: “Those are the companies where you would need a compelling reason to be involved. What we’ve seen is that over time those are the ones where something will happen and that’s where you get the underperformance.”
He points to Brazilian poultry business JBS as an example, noting the credit team had been reducing its holding as its ESG score decreased when the company became caught in a corporate scandal surrounding the quality of its products.
The research also found there is a “significant, positive” relationship between ESG scores and credit ratings, but the range of ESG scores is broad across all rating categories.