This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC, as well as a contributing analyst to S&P Global Market Intelligence.
ESG-qualified Energy issues' March 2020 performance
A previous commentary, "ESG outperformed as COVID hit, but does not guarantee alpha," received some thoughtful press coverage (see note 1). The Financial Times article generated a lively online discussion of our findings. We hope the demonstrated investor interest in this topic will encourage others to conduct research on environmental, social and corporate governance factors in high-yield returns. Many avenues remain to be explored.
Consider, for example, our basic finding that, although ICE Indices' three ESG-related high-yield indexes outperformed the ICE BofA US High Yield Index during the severe downturn of March 2020, that edge arose from a side-effect of the ESG-based index selection process. Removing bonds with poor ESG scores raised the remaining universe's average rating and lowered its concentration in Energy. Consequently, when CCC & Lower and Energy issues radically underperformed the standard high-yield index in March 2020, the ESG-based indexes substantially outperformed. Our prior piece compared returns of ESG-qualified and non-ESG-qualified issues and concluded that the ESG-related indexes’ March 2020 outperformance could not be attributed to their favorable ESG characteristics.
Investors were neither rewarded nor punished, we found, for avoiding ESG "bad citizens."
Removing Energy issues from our issue-level comparison raised a question in some readers' minds about our results. The environmental impact of fossil fuels is a leading concern of investors who are focused on the E in ESG. Should the ESG-based indexes, they wonder, not get credit for eliminating Energy issues in a performance matchup with the standard high-yield index?
Our reasoning was that Energy bonds would have substantially underperformed in March 2020 even if nobody had been concerned about climate change, simply because oil prices collapsed in that period. There was no obvious way to break down the ICE BofA US High Yield Energy Index's -33.77% return for the month into oil-price-driven and ESG-driven components. On the other hand, there were hundreds of issues in both the ESG Good Citizen and the ESG Bad Citizen categories to enable us to run a statistically valid test of whether an ESG-related factor could be isolated in March 2020's comparative returns.
The analysis summarized in the chart below may contribute usefully to the ongoing investigation into ESG effects in the high-yield market. A handful of Energy issues qualify for inclusion in the ICE US High Yield Optimized ESG Tilt Index, also labeled "Best-in-Class." We compared those 11 bonds' March 2020 returns with the medians of their non-ESG-qualified peer groups, constructed as described in the chart's notes.
The number of test issues and the sizes of the peer groups were both small, so investors should treat these findings with caution. With that proviso, the red and black figures in the Difference column show that only 5 of 11 ESG-qualified Energy issues outperformed their peers. This is as close to a tossup as possible, given the odd number of test issues.
Note, however, that there were multiple issues for the first two issuers listed. What happens if we tally the results by issuers instead of issues? Precision Drilling (US) Corp. is clearly in the Underperform category, 3 issues to 0. Cheniere Energy Partners LP, with 2 out of 3 issues underperforming the peer group, and with the third outperforming only by virtue of drawing a much easier peer group matchup, can also be counted as an underperformer. By this calculation method, a majority, 4 out of 7 issuers, beat their peer groups. Once again, though, the split is as close to 50/50 as possible, given the odd number in the sample.
We conclude, based on the limited available evidence, that Energy companies with good ESG scores show neither a tendency to provide nor not to provide superior downside protection in a high-yield bear market. Notably, though, the most conspicuous clean energy issue in the group, Topaz Solar, was the group's best performer by a healthy margin, with a total return of -8.80%. Topaz achieved the distinction despite having the lowest Composite Rating in the group, at CCC2. This result raises the tantalizing possibility that if the category of high-yield clean energy issuers expands in coming years, there may ultimately be a bona fide path to high-yield alpha that leads through ESG scores. In the meantime, some investors may make the bet that they can boost their risk-adjusted returns by avoiding Energy, not because of ESG concerns, but simply because of the industry's high volatility.
We hasten to add that zero-weighting the high-yield index's largest industry may impose hidden costs. High-yield mutual fund managers frequently find themselves under pressure to put money to work. With the biggest group of issues off the table, managers might be forced to make suboptimal security choices that ultimately prove costly.
Two final notes: First, our previous investigations have elicited the comment that the apparent lack of a performance edge for ESG-conscious investors may be a function of shortcomings in the scores assigned by the ESG raters. Some high-yield managers contend that the best way to obtain ESG-related alpha is not to rely on the scores, but instead to integrate ESG analysis into their own credit analysis to obtain holistic pictures of the issuers. Second, on a lighter note, the symbols for two issuers in the chart above are anagrams for each other: Tervita Corp.'s TEV and Vermilion Energy Inc.'s VET. We invite readers to identify any other examples of such pairs within the high-yield universe, with extra points awarded if the two companies are, like Tervita and Vermilion, in the same industry.
Research assistance by Lu Jiang and Zhiyuan Mei. Additional research assistance by Daniel Navaei.
ICE BofA Index System data is used by permission. Copyright © 2020 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC's use of such information. The information is provided "as is," and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
1. See, for example, Billy Nauman, "ESG screens provided no protection in virus sell-off," Financial Times (Aug. 11, 2020); "SRI and high yield: does it work?" Banking Exchange (Aug. 13, 2020).
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