ESG Investing in the U.S. High Yield Corporate Bond Market

More than a year into a global pandemic and with climate change manifesting its power around the planet, investors’ appetite for sustainable ways of exploiting opportunities in the world’s financial markets has accelerated. Recent studies into the perceptions of global investors reveal that this has been a global trend independent of geographical, scale-of-business, or asset-class considerations.

Investors need the right tools to assess both the strength of companies’ standing in terms of their environmental, social, and governance (ESG) policies and practices and in terms of allowing investors to integrate that ESG information into their investment portfolios. We set out to answer this question: is it possible to build a systematic, long-only, smart-beta framework that gives investors an enhanced exposure to U.S. high-yield (HY) corporate bond issuers that score highly on ESG dimensions while at the same time preserving major performance and risk characteristics of investing in a traditional value-weighted U.S. HY corporate bond benchmark index?

To conduct our analysis, we built a benchmark index that closely tracks the performance of the high-yield segment of the U.S. corporate bond market. We also leveraged the Truvalue Labs’ ESG scoring methodology to gauge individual company performance across the ESG spectrum.

A systematic ESG-focused smart-beta framework features the following key pillars:

• ESG Exposure: Significantly and consistently greater exposure to high-ESG-rated corporate bond issuers than the benchmark
• Yield Generation: Yield-generating capability at least the same as that of the benchmark ensuring that investors reap the full benefits of fixed-income streams offered by the traditional high-yield corporate bond benchmark
• Interest Rate Risk Control: Smart-beta sensitivity to Treasury market dynamics that ensures investors are neither more nor less exposed to movements in the general interest rate environment than if they were to invest in the benchmark
• Reinvestment Risk Control: Embedded options in corporate bonds make investors additionally susceptible to general interest rate dynamics and the smart-beta framework ensures that this additional source of fixed-income risk is strictly controlled within the range of reinvestment risk exposure implied by the benchmark

Empirical evidence on how our smart-beta framework performs on these dimensions is provided below based on a quarterly backtest spanning the period June 2011 to June 2021. Exhibit 1 provides a comparison between the ESG exposures of the smart-beta portfolio and the benchmark on a level basis (left), and on a percent difference basis (right). We appear to have achieved a minimum 20% ESG exposure outperformance versus our proxy of the broad U.S. HY corporate bond market.

Does the enhanced ESG exposure imply a compromise on the yield income that investors can earn over the long term compared to our traditional benchmark? The answer is no. Yield control is an integral part of our smart-beta portfolio that ensures that the yield to maturity (YTM) of the ESG-focused portfolio stays closely aligned with and never declines below the YTM profile of the benchmark portfolio. This close YTM alignment between the smart-beta and benchmark portfolios is documented in the left plot of Exhibit 2. We identified the component of the portfolio’s total cumulative return that is solely attributed to the fixed-income nature of the corporate bond securities—coupon payments and accrued interest. This cumulative total return component is depicted in the right plot of Exhibit 2 and demonstrates that our smart-beta framework can provide the same level of fixed income over the long term as a traditional HY corporate bond benchmark but with a significantly enhanced exposure to companies that score high across the ESG spectrum.

As stipulated above, controlling various important sources of fixed-income risk is an integral part of the ESG-focused corporate bond smart-beta framework. We ensure strict alignment between the smart-beta effective duration with the benchmark effective duration levels (left plot in Exhibit 3) that allows the component of the smart-beta total cumulative performance attributed to exposure to shifts in the underlying Treasury curve to be closely aligned with that of our U.S. HY benchmark portfolio (right plot in Exhibit 3).

We report total cumulative performance results for the smart-beta and benchmark portfolios in Exhibit 4. Both on an actual and risk-adjusted basis the two portfolios exhibit similar performance profiles. Enhancing the portfolio exposure to the highly-rated end of the ESG spectrum does not need to compromise the ability of investors to fully benefit from the performance profile of a traditional U.S. HY corporate bond benchmark.

Enhancing the ESG profile of our benchmark HY corporate bond index does not compromise the performance of the portfolio in periods of market downturn as documented in Exhibit 5.

The analysis in this report highlights the existence of a systematic smart-beta framework that can serve the dual goals of significantly increasing investors’ exposure to corporate debt issuers that score highly across the ESG dimensions and of preserving the performance and risk characteristics of a traditional value-weighted passive approach to investing in the U.S. HY corporate bond market.

Georgi Mitov and Antti Harju also contributed to this article.

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