Key findings

The study assessed the impact of incorporating environmental, social, and governance (ESG) factors on corporate bond portfolios. ESG ratings were found to provide distinct insights beyond traditional credit ratings. Higher ESG-rated issuers typically showed stronger cash flow metrics, lower levels of risk, and fewer severe incidents compared to lower-rated peers. Aggregate ESG scores were more effective in reducing risk than individual E, S, or G pillar scores. The social pillar showed the strongest return performance, while the environmental pillar differentiated risk most clearly.

Data and methodology

The analysis covered January 2014 to June 2020, using issuer-level data from the MSCI USD and EUR Investment Grade (IG) and High Yield (HY) Corporate Bond Indexes. The sample was restricted to issuers with available ESG scores, with analysis conducted across terciles based on industry-adjusted ESG scores. This approach allowed a best-in-class comparison within industries. Results were tested across cash flow, systematic-risk, and idiosyncratic-risk transmission channels using financial variables and regression models that controlled for credit ratings and other bond factors.

ESG and traditional corporate-bond metrics

Option-adjusted spreads (OAS) reflected market pricing of credit risk. Bonds issued by higher ESG-rated firms consistently had tighter OAS compared with lower ESG-rated bonds across both IG and HY markets. The differences were more pronounced in HY bonds than IG, and within IG were stronger in longer-dated maturities. These findings aligned with credit-risk theory suggesting ESG has greater impact where default probability is higher.

Economic-transmission channels into credit risk

Cash flow channel – High ESG-rated firms displayed stronger net profit margins, higher return on equity (ROE), and better interest coverage ratios than lower-rated firms. These advantages translated into stronger credit quality, with high ESG-rated issuers showing a wider distance to default.

Systematic-risk channel – High ESG-rated issuers exhibited lower systematic volatility, particularly in HY bonds. Longer-dated IG bonds also benefited from stronger risk reduction. These issuers faced lower costs of debt capital, as credit spreads were consistently narrower, even after adjusting for credit quality. Consequently, higher ESG ratings were associated with higher valuations.

Idiosyncratic-risk channel – High ESG-rated issuers had a lower likelihood of severe incidents and reduced tail risks. Value-at-risk analysis showed that lower ESG-rated issuers had greater downside exposure. Residual volatility and idiosyncratic drawdowns were lower for high ESG-rated issuers, particularly in HY markets.

Performance of ESG in corporate bonds

Performance analysis from January 2014 to July 2020 found that portfolios of high ESG-rated issuers generally outperformed low-rated peers in residual returns, particularly in the composite and EUR IG universes. Risk reduction was observed across all universes, with the largest effect in USD IG bonds. Combining all three pillars into an overall ESG score provided stronger results in reducing risks than individual pillar scores. Governance scores were the least effective, possibly due to governance risks already being incorporated into market pricing.

Conclusion

The analysis confirmed that ESG ratings provide additional information beyond credit ratings in assessing corporate bond risk and performance. High ESG-rated issuers demonstrated better financial strength, lower systematic and idiosyncratic risks, and more resilient credit quality. The benefits were particularly evident in HY bonds and longer-maturity IG bonds. Aggregated ESG scores delivered the clearest signals, suggesting that investors can enhance risk management by integrating ESG considerations alongside traditional credit analysis.