Though traditionally, it has been more difficult to price in ESG risks accurately, the fund house has devised a new model based on charting an issuer’s ESG score with the spreads on their credit default swaps.
Hermes applied its own quantitative ESG (QESG) score to the companies included in the study, which builds on Morningstar’s Sustainalytics research, as well as data from MSCI data and other third parties and findings from Hermes’ own in-house team.
Looking at the CDS spreads of 365 companies between 2012 and 2016, the Hermes team found that companies with higher ESG scores tended to have lower credit default swap spreads.
Companies with a QESG score of one out of a possible five, with five representing issuers that scored the highest on ESG concerns, had an average annual credit default spread of around 250 bps.
Whereas issuers that earned a five QESG rating, had CDS spreads just above 100 bps on average.
Across the main sub-categories of environmental, social and governance, the team found that there was a similar correlation between a high score in one area and lower CDS spreads.
Environmental, social, governance factors and behaviours are something that both equity and credit investors should pay attention to, the investment firm argued, because of the impact on valuations.
“Although credit risk is the principal driver of both the level of and changes in credit spreads, we know that ESG factors also influence credit spreads,” said Hermes credit co-head Mitch Reznick.
However, the credit team discovered there was less of a clear-cut connection between a company’s ESG score and credit rating.
Their research yielded a number of false positives. Several companies with A or BBB credit ratings had low QESG scores, for example.