The Bond Bandit – Seize The Anti-ESG Premium | #ukscams | #datingscams | #european | #datingscams | #love | #relationships | #scams | #pof | #match.com | #dating

Introduction

In the context of bond investing, I started thinking about the idea of an “ESG risk premium” – a premium demanded by the market from companies with poor ESG (environmental, social, governance) ratings – when I first heard about the EU taxonomy for sustainable activities. The bloc’s recent activities represent a regulatory push for (or outright mandate for) investment in “sustainable” activities and a potential penalizing of “unsustainable” investments. Clearly, the EU is leading the way in this regard, aiming to become the first climate-neutral continent (“European Green Deal”).

While the concept is becoming more concrete, the European Banking Authority (EBA) already formulated a number of proposals two years ago on how to adequately measure and account for sustainable investments. To give one example:

“[…] credit institutions should disclose their green asset ratio (GAR) to show the extent to which the financing activities in their banking book (including loans and advances, debt securities and equity instruments in the banking book) are associated with economic activities aligned with the EU Taxonomy and are therefore Paris Agreement- and SDG-aligned.“

Page 4, Opinion of the European Banking Authority on the disclosure requirement on environmentally sustainable activities in accordance with Article 8 of the Taxonomy Regulation.

It clearly appears that the market is increasingly demanding a higher interest rate from companies with poor ESG ratings, in part because institutional investors such as banks are increasingly discouraged from engaging in such activities. Of course, the above statements all refer to the European Union, but I argue that the U.S. is also moving in the same direction, albeit at a slower pace.

So, in this article, I explore the question of whether there is such a thing as an “ESG risk premium” in bond investing, and more importantly, whether there are ways to take advantage of it as a retail investor who is not held to the same regulatory standards as institutional investors.

A Word On ESG, ESG Ratings, And My Methodology

I do not want to be misunderstood with this article. In my view, the topic ESG is often interpreted as focusing on either environmental aspects (e.g., pollution, “overuse” of “finite” resources) or social aspects (e.g., diversity, inclusion, gender pay gap, occupational safety). While I personally believe it is important for company management to consider these aspects, it is at least as important not to forget the very raison d’être (e.g., profit, profit growth). Clearly, the priority must be to remain competitive and profitable.

However, I believe many investors undervalue the governance aspect of ESG. In this context, rating agencies such as Moody’s, Morningstar Sustainalytics, and MSCI also look at CEO compensation, the combination of CEO and chairman positions, inadequate auditing processes, over-boarded directors, lack of or inadequate performance targets, etc. As an investor doing my own due diligence, I obviously investigate these issues myself using primary data from company financial statements, but I can’t deny that I appreciate rating agencies pointing out potential issues.

ESG ratings are a hot potato to discuss – not only because of the aspects mentioned above, the greenwashing concerns, but also because of the often inconclusive results of the rating agencies. For example, comparing the ESG ratings from Sustainalytics and Moody’s (Credit Impact Score, CIS) for a set of 60 large companies from the U.S., Europe, and Australia, I obtained a rather disappointing correlation coefficient of 0.40. Moody’s, however, divides its CIS into three components and gives an ESG issuer profile score (IPS) for each of the three categories.

For example, consumer goods giant Procter & Gamble Co. (PG) has a CIS of 1, but scores only three out of five in the environmental and social IPS categories. Apparently, the company’s top-notch score in the governance segment earned it a CIS-1 rating, suggesting that good governance is more important to the CIS than the other aspects. One could argue that this actually makes sense. After all, how credible are a company’s claims about social and environmental aspects if its governance is poor? Conversely, Johnson & Johnson (JNJ) has a similar E-IPS and S-IPS rating as P&G, but despite its top-notch governance (G-IPS rating of 1 out of 5), the company only received a CIS of 3 out of 5. Moody’s ESG rating methodology is explained in detailed in this document.

To account for these ambiguities and achieve a better correlation, I calculated an “equally-weight CIS” by adding the scores of each company in the three categories. This improves the correlation between the Sustainalytics and Moody’s rating systems to a correlation coefficient of 0.61.

While it would be nice to gauge for a potential ESG premium at the example of a very large number of companies in a single chart, there are some obstacles. The observable I use to determine the magnitude of a potential ESG premium is the interest rate on a company’s debt – or more precisely, its yield-to-maturity (YTM). Before focusing on the ESG aspect, it is therefore important to look at the key factors that influence interest rates.

Credit risk is probably the most important aspect that affects the interest rate on a company’s debt. Therefore, it is important to compare only interest rates in the same rating category and with the same rating outlook. However, do not forget that there is also currency risk and interest rate risk (related to refinancing on the investor side). By focusing on bonds denominated in U.S. dollars, we can reasonably exclude currency effects – it would not make sense to compare, for example, YTMs of U.S. dollar-denominated and euro-denominated Philip Morris International Inc. (PM) bonds given the different yield curves (Federal Reserve vs. European Central Bank). Interest rate risk (investor side refinancing risk, see my related article) is best addressed by not focusing on a single duration, but instead comparing yield curves. This is what I referred to as a “representative bond portfolio” in the summary bullets.

Since I use relatively large data sets, it was of course not possible for me to study the prospectuses of the individual bonds and therefore not to exclude bonds with issuer call options. As a result, the yield curves may occasionally show irregularities. Other (minor) effects that might affect the YTM, such as the lot size of the bonds, have not been taken into account.

As a result, I have focused on a one-by-one comparison of a manageable number of companies in order to adequately address the most important aspects affecting bond yields. While I acknowledge that I could be accused of “cherry-picking,” I have selected companies whose “equal-weight CIS” and Sustainalytics ratings are relatively highly correlated. The ratings of the 14 companies compared in this article yield a correlation coefficient of 0.74 (Figure 1). Interestingly, the rating agencies seem to disagree on the higher-rated companies, while they agree better on the more negative ratings of mining, tobacco, and oil and gas companies.

Investigation And Confirmation Of The ESG Premium Hypothesis

Microsoft Corp. (MSFT) Vs. Johnson & Johnson (JNJ) – Long-Term Credit Rating Aaa

Besides Apple Inc. (AAPL), Microsoft Corp. and Johnson & Johnson are the only companies in the U.S. with a long-term credit rating of Aaa and a stable outlook. Figure 1 shows that Microsoft has received a top ESG rating from both Sustainalytics and Moody’s. Johnson & Johnson, despite its excellent governance rating, received only a CIS of 3 out of 5, due in part to its ongoing talc litigation and other environmental and social issues (see my latest article). Sustainalytics rated JNJ at 24 points, which corresponds to medium ESG risk.

Comparing the yield curve of the outstanding dollar-denominated bonds of the two companies for which I found market data, no ESG risk premium is apparent (Figure 2). I attribute this to the still acceptable ESG ratings of JNJ (there is no poorly-rated Aaa company for comparison), but also the Aaa credit rating of the two companies and thus the already low spread to U.S. government bonds (obtained July 13, 2023, black line in Figure 2 and all subsequent figures).

Alphabet Inc. (GOOG, GOOGL) Vs. Exxon Mobil Corp. (XOM) – Long-Term Credit Rating Aa2

Moving down two rating notches, the comparison becomes much more interesting. Alphabet has a very good ESG rating from Moody’s and a still good rating from Sustainalytics (Figure 1). Exxon Mobil is rated the worst among the group of companies discussed in this article. While the company has received a fairly positive G-IPS from Moody’s, its E-IPS and G-IPS are abysmal – 5 out of 5.

A look below at Figure 3 clearly shows that ESG-aware investor demand for XOM debt is quite low compared to demand for Alphabet issues. A premium of about 40 basis points, which I attribute to Exxon’s poor ESG rating, can be pocketed by investors who don’t have to adhere to (future) regulatory standards and don’t mind investing in oil and gas companies. What I find fascinating is that the spread is maturity-invariant and is already present in rather short-duration bonds.

Nvidia Corp. (NVDA) Vs. BHP Group Ltd. (BHP) – Long-Term Credit Rating A1

In the top tier of high investment grade category, Nvidia, the GPU and API giant, and BHP Group, the mining company, are a similarly interesting comparison. The latter company, not hard to understand, currently has an E-IPS rating of 5 from Moody’s, while NVIDIA Corp. has been rated E-3, S-2 and G-2. Again, there is a significant YTM spread, albeit somewhat narrower than in the case of GOOG/GOOGL versus XOM – at only about 20 to 35 basis points. The spread narrows as bonds mature further into the future, but given the limited data available, I would not over-interpret this aspect.

The Home Depot Inc. (HD) Vs BP p.l.c. (BP) – Long-Term Credit Rating A2

Next in line are A2-rated Home Depot and BP p.l.c.. There is plenty of bond data to suggest that there is only a small ESG risk premium of about 10 basis points to investing in BP’s dollar-denominated debt rather than HD’s. I attribute this to BP’s transformation efforts and the consequently probably still quite good standing with institutional investors from Europe.

One could argue that BP’s 2033 bonds (current YTM of 5.0%) are a pretty good deal as part of a traditional 60/40 portfolio. However, and despite BP’s efforts, I think it is important to keep in mind that ESG-related lending and investment regulations are still in their infancy, so I personally would only consider investing in these bonds if I expect to hold them to maturity. An increase in ESG risk spread would result in a decline in the value of the bond, all other things being equal.

Comcast Corp. (CMCSA) Vs. Altria Group Inc. (MO) – Long-Term Credit Rating A3

Comcast and Altria’s bonds have a fairly high ESG spread of 30 to 90 basis points, although Altria has fairly good E-IPS and G-IPS ratings of 3 and 2, respectively. It is not difficult to understand why Altria’s business model has resulted in a poor S-IPS rating and thus a fairly high overall score of 10. In my view, the rating discrepancy is the main reason for the YTM spread of 50 to 90 basis points in long-term bonds. Based on a $10,000 investment, Altria investors can earn about $2,000 more over the next 20 years than buyers of comparable Comcast debt.

Tobacco companies “enjoy” the worst reputation among non-ESG investments, in my view. This is also one reason for the comparatively favorable valuation of their shares.

Lowe’s Companies (LOW) Vs. Glencore p.l.c. (OTCPK:GLCNF, OTCPK:GLNCY) – Long-Term Credit Rating Baa1

Looking at a large commodity trading and mining company in the lowest investment grade credit category also confirms the ESG risk premium hypothesis. Compared to Lowe’s Companies, investors in Glencore debt can pocket over 100 basis points ESG premium in the 12 to 14 year maturity range. Of particular note, Moody’s upgraded Glencore’s rating outlook to positive in October 2022. Hence, the credit ratings should not be viewed as identical, so the actual ESG spread is likely somewhat higher. Conversely, the actual achievable spread could be somewhat lower due to curve interpolation between Lowe’s 2033 and 2047 notes.

Elevance Health Inc. (ELV) Vs. British American Tobacco p.l.c. (BTI, OTCPK:BTAFF) – Long-Term Credit Rating Baa2

Last but not least (my regular readers know why), I couldn’t resist taking a look at British American Tobacco’s ESG spread. Unsurprisingly, “unscrupulous” tobacco bond investors earn over 100 basis points more on their capital in the 8 to 18 year maturity range compared to the bonds of the top-ESG-rated health insurance provider Elevance.

Conclusion

Same as ESG-factor-investing, “anti-ESG” investing is not for everyone. To take a balanced approach, I believe it is important not to ignore ESG ratings carelessly, as they can contain very important information about a company’s governance structure, even if an investor is not interested in environmental and social issues.

Although the dataset examined in this article is certainly limited, the results suggest that ESG-related investment restrictions (self-imposed or at some point enforced by regulation) have already led to an interest rate premium on debt securities of companies with comparatively poor ESG ratings. Given that ESG risks should be readily factored into the credit risk profile of the company in question (Moody’s, for example, refers to its ESG rating as “Credit Impact Score”), it is reasonable to conclude that the premium is (almost) entirely due to the effects mentioned above.

Depending on the rating category and long-term company strategy, investors can pocket a more or less significant premium when investing in debt of poorly-ESG-rated companies. Tobacco companies likely “enjoy” the worst reputation among non-ESG investments.

At the same time, equity investors in companies with comparatively poor ESG ratings need to keep in mind that in the face of a most likely stricter regulatory framework (possibly culminating in outright lending restrictions in some jurisdictions), the emphasis on a solid balance sheet is more important than ever.

As always, please consider this article only as a first step in your own due diligence. Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there’s anything I should improve or expand on in future articles, drop me a line as well.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.