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

In this new 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.

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RMBS default rates trending higher as house prices plunge

Coolabah developed the world’s first compositionally-adjusted, or hedonic, regression-based index of RMBS default rates, covering all prime deals that Bloomberg reports on (you can download the paper here). We update this index monthly, and the results are enclosed below.

Contrary to S&P’s SPIN Index, we find that Aussie RMBS arrears (nb: legally there is no difference under home loan contracts between being in “default” and in “arrears”) have been steadily climbing since 2014. This is consistent with the RBA’s latest data on home loan default rates, which Governor Phil Lowe published during the week (see chart below). Observe that according to both the RBA and Coolabah’s indices, defaults have been rising for many years. In fact, Aussie RMBS arrears are approaching their GFC peaks.

At the same time, house prices are experiencing their biggest falls in 40 years (see Sydney chart below), which is particularly negative for RMBS because the only thing protecting the bond is the value of the home. This in turn means that leverage or the loan-to-value (LVR) ratios underpinning recently issued RMBS are likewise rising fast. When we model deals on a bond-by-bond basis we see big spikes in the share of borrowers with LVRs over 80% and 90% in deals issued since 2017.

Another significant negative for Aussie RMBS is that prepayment speeds are dropping like a stone (see our numbers below), which blows out the expected life of the bond and therefore reduces the expected credit spread an investor is earning relative to the spread they assumed when they bought the bond.

The deflation of the great Aussie housing bubble in an orderly fashion while the unemployment rate has fallen from 6.4% to 5.0%, GDP growth is demonstrably positive and higher than most OECD countries, the government’s budget is almost in balance, and the sovereign’s credit rating has been recently upgraded to AAA “stable”, is exceptionally positive from a financial stability perspective and credit positive for the banks on a medium term basis. This is because the banks have government-guaranteed funding via deposits, access to emergency RBA liquidity, and the prospect of government-guarantees of their senior bonds during crises. They are also constantly refinancing their home loan books with better quality assets written according to tighter lending standards. Finally, the Aussie banks in particular have slashed risk-weighted leverage in half since 2014 with the biggest build-up in equity capital in modern banking history as a result of APRA’s new “unquestionably strong” capital framework.

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