SSGA-SPDR: The long-term case for ESG US Investment Grade Credit

June 17, 2021

Investment grade (IG) credit has rebounded in Q2 2021, following a weak start to the year. The combination of a shift lower in US Treasury yields, as investors have dialled back on their bearishness, and a gradual compression of spreads to Treasuries have produced returns for an all maturities index of over 2.5%. 

Outright yields of more than 2% make these strategies interesting to EUR-based investors, in particular, where fixed income yields remain low.

There are of course currency risks, which have proved non-trivial given the rise in EUR/USD above 1.21 from just below 1.18 at the start of this quarter. However, with interest rate spreads relatively compressed from a historical perspective, these can be cost effectively hedged out.

On the flows front, the trend for money coming into IG credit remains, with assets mainly finding their way into ESG credit strategies. This trend has been driven by social change, new rules and a better understanding of ESG performance as evidence emerges that an ESG approach can both help reduce volatility and enhance longer-term performance.

The view from Europe: hedging may be worth considering

The yield pick-up to European IG credit looks generous at around 175bp on an unhedged basis and so should appeal to European investors who have to make do with a yield of just under 30bp on the Bloomberg Barclays Euro Corporate Index. However, with the cost of hedging having come down significantly over the past few years, hedging out the FX risk makes sense. When adjusted for the cost of the hedging, the yield differential of just under 120bp offers the greatest pick-up since mid-2017.

On the topic of hedging, the EUR has rallied back above 1.21 versus the USD, not that far short of the five-year high of just above 1.25. For investors who may be sceptical of the urgency to hedge out USD risk, it is worth remembering the EUR/USD hit 1.39 in 2014. Meanwhile, the fundamentals that underpin the USD include a widening US current account deficit, a large budget deficit and structurally higher inflation than the euro area, which all point to potential further declines.

Performance attribution shows ESG ability to reduce volatility and enhance long-term returns

Evidence that higher-scoring ESG companies are typically more stable can be observed during the COVID-19 crisis. During the period from the end of 2019 to the end of March 2020, the crisis period, the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index returned -205.9bp against the Bloomberg Barclays US Corporate index return of -363.4bp. 

Figure 1: Performance attribution for the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index vs. the Bloomberg Barclays US Corporate Index

A performance attribution suggests that asset allocation mostly drove the divergent outcomes. This makes sense given some of the worst-performing areas of the corporate bond market were energy and transportation, which are both sectors where the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index has a substantially lower weight than the parent index.

 Conversely, the heavier weighting of the ESG index to technology provided support, as the sector holds names that, on the whole, were perceived to benefit from the work-from-home environment. The effect can be seen in Figure 2, where monthly drivers of relative performance are shown. The lower weighting toward energy is a clear reason behind the ESG index’s outperformance during Q1 2020.

In contrast, the period since the end of March 2020 saw a general compression of credit spreads, not least because the Federal Reserve (Fed) announced that it would start to buy corporate bonds. This Fed safety net resulted in some of the most oversold bonds enjoying the sharpest rebounds. It should be no surprise that the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index struggled to match the performance of the parent index, with returns of 472.8bp against 524.3bp for the Bloomberg Barclays US Corporate Index.

Sector-wise, energy flipped from being a boost to the SASB ESG index’s relative performance to being an impediment as oil prices rebounded. Technology also swung from a key support for ESG performance to a drag.

Figure 2: Performance attribution by sector for the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index vs. the Bloomberg Barclays US Corporate Index

The attribution also shows an ESG effect through security selection (Figure 3). This contributed in excess of 50bp of outperformance in Q1 2020 and suggests that, in times of stress, the issuers with lower ESG ratings are the most aggressively offered in the market. Unsurprisingly, there is a heavy overlap to the sectors that were the big movers, such as energy. REITs and tech also made a significant positive contribution in March 2020, although tech stock selection actually acted as a relative drag on performance in January and February. Security selection in basic industry and banking also contributed negatively.

Since March, there has been some ‘payback’ with security selection weighing on the relative performance of the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index. However, this effect has been modest with security selection contributing just -12.7bp to the ESG index, so falling well short of reversing the gains made during the crisis period. Indeed, the only month of significant drag was April 2020, during the immediate rebound from the crisis.

Figure 3: Performance attribution by security selection for the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index vs. the Bloomberg Barclays US Corporate Index