“We think that these high ESG companies are more likely to be protected from additional risks,” Dynkin says. “They increase returns because they’re protected from negative environmental and regulatory impacts. Their good governance and high social ratings may help protect them from strikes or protests.”
Part of the benefit also has to do with the way bonds are traded -- bonds with high ESG scores trade at lower-than-average spreads, and investors interested in ESG are more likely to hold onto their investments over a long term.
High-ESG bonds have not encountered increasing relative valuations over the past eight years, according to Barclays, which implies that their performance gain is not related to buying pressure.
In the MSCI data, there was a 38-basis-point average spread between high and low ESG bonds, while Sustainalytics measured a spread of 35 basis points. The difference also accounted for a one-tick improvement in average credit quality, from A3 to A2.
The study was only able to look back eight years, according to Dynkin, because the ESG ratings systems are still relatively new and have limited data sets.
“This is a young industry and these numeric ratings are relatively recent,” Dynkin says. “We would like to have had a much longer period, but we could only go back to the point where both ratings systems had data for a sufficient number of issuers.”
Dynkin also warns that the outperformance is only present when portfolios are constructed using ESG scoring and ranking, not when negatively screening for ESG characteristics.
“The ranking approach is better because eliminating entire industries or sectors creates systemic risks in the portfolio that may lead to underperformance,” Dynkin says. “Using a ranking system to give a portfolio an ‘ESG tilt’ does not include that systemic risk.”