Stronger ESG Practices Lead To Tighter CDS Spreads

Companies with stronger environmental, social and governance (ESG) practices benefit from tighter CDS (credit default swaps) spreads than those with poorer ESG procedures, according to new data from the Credit and Responsibility teams at Hermes Investment Management.

Pricing ESG risk in credit markets: reinforcing our conviction, follows on from a 2017 study conducted by the teams to develop a pricing model to capture the influence of ESG factors on credit spreads. This showed a convincing relationship between ESG characteristics and credit spreads manifesting as an ESG risk curve. This year, the teams expanded the research to include an additional 500 data points.

The research found that:

• Companies with higher QESG Scores, i.e. the strongest ESG credentials, have tighter credit spreads than those with lower QESG Scores.
• Even after controlling for credit ratings, there is still a significant correlation between CDS spreads and the ESG performance of companies.

The model generated by the research’s insights helps identify mispriced issuers based on their ESG characteristics. Investors should be wary about issuers with very low credit spreads and a very poor ESG performance.

Mitch Reznick, CFA, Co-Head of Credit, Hermes Investment Management, said: “While the industry has spent years of intellectual capital on pricing operating and financial risks – the core credit risks – we were frustrated that there was no equivalent for ESG. As a result we decided to develop in-house research to examine the relationship between ESG factors and credit spreads. The ESG credit curve that we ended up with is an early, pioneering attempt to price ESG risks.”

Dr. Michael Viehs, Associate Director – ESG Integration, Hermes Investment Management, said:“This research reinforces the necessity of integrating ESG factors into investment decision making in fixed income. Our analysis shows that credit ratings are still not fully capturing the ESG risk dimension of an issuer and therefore it helps us identify issuers whose deteriorating ESG practices could lead to underperformance. By replicating and extending our previous research, we found a stronger relationship between CDS spreads and QESG Scores which matches our qualitative assessments.”

Source: Hermes