By the Cross Asset and ETF Research Team at Lyxor Asset Management.
Why adding an ESG tilt to your high-yield bond portfolio could be beneficial
High-yield bonds could be a useful addition to many investors’ portfolios as they offer attractive return potential and good diversification benefits. And yet they’re not without risk. One way to reduce the risk of such an allocation could be to invest in an index that takes ESG criteria into account in its construction process.
High-yield bonds can provide some attractive benefits
High-yield bonds are bonds issued by companies that have been rated below investment-grade by the primary rating agencies. While they are fixed income instruments, to a certain extent they act like bond-equity hybrids as they combine some characteristics of both asset classes. Some of the main reasons they appeal to investors are:
- the extra yield they provide over investment-grade credit and government bonds
- their potential for significant capital appreciation if an issuing company’s financial health improves and a bond’s rating is upgraded
- their diversification benefits given relatively low correlation with other fixed income classes
Source: Lyxor Asset Management.
The risk of default
The ultimate risk for fixed-income investors is that a bond they hold defaults. In 2019, the default rate for high-yield bonds was at 3.0% – significantly below the 4.1% average since 1983. The rate also remains below the 3.5% annual average observed during non-recession years.
Source: Lyxor Asset Management.
In the US, the Oil & Gas sector accounted for a fifth of overall defaults last year and is likely to remain one of the largest contributors to overall defaults in the year ahead and beyond given energy transition. The chart below shows high yield indices with an ESG tilt have historically been less exposed to the Energy sector.
Source: Lyxor Asset Management.
Looking ahead, Moody’s anticipates a higher level of defaults in 2020 in both Europe and the US, but these should remain lower than the long-term average in non-recession years.
An ESG tilt can improve a high-yield portfolio’s risk-return profile
The primary focus for bond investors is often on mitigating downside risk rather than capturing upside potential. Taking ESG factors into account could be a good way of reducing exposure to future risks which could lead to default. For example, a polluting company might be subject to litigation in the future, hitting the value of its bonds, while a firm with poor governance may take part in practices that could make it less likely to be able to repay its debt. What’s more, companies with lower ESG scores tend to have a higher chance of a rating downgrade than firms with better ESG scores, according to Bloomberg Barclays data.
When comparing the characteristics of an ESG high-yield index with a broader high-yield benchmark in the table below, we see that the index including companies with higher ESG ratings has lower spreads, stronger financial metrics and a lower probability of default.
Source: Lyxor Asset Management.
Protecting value during times of stress
To analyze whether an ESG tilt can improve the performance profile of a high-yield bond portfolio in periods of market stress, we looked at the performance of high-yield bond indices in the global market sell-off of Q4 2018. We can see from the left-hand chart below that high yield indices with an ESG tilt have been more resilient in the period of market stress compared to broader high yield bond indices. The right-hand chart shows us that bonds with a low ESG rating or that are non-ESG rated were more subject to larger losses over this period of market stress.
Source: Lyxor Asset Management.
Adding to our ESG range on corporate bonds
At Lyxor ETF we’ve launched a new range of US, Euro and global high-yield bond ETFs that includes MSCI ESG criteria in the construction process. These funds add to our existing offering of SRI corporate bond indices, which already includes both investment-grade and floating-rate-note strategies.
Source: Lyxor Asset Management.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)