Are ESG Alpha and Beta Benefits in Corporate Bonds a Mirage

Employing linear and non-linear techniques for assessing the relationship between ESG factors and future returns and risks on an out-of-sample basis, we find that the best and worst quintile portfolios ranked on their ESG scores were statistically significant in generating alpha and reducing beta for equities in Australia and the US, but not for those located in Europe and Japan. In the US corporate bond market, which has the largest available data-set, we can identify no statistically significant effects on alpha (in the CAPM sense), but ostensibly significant beta reduction benefits. Importantly, however, we demonstrate that better (worse) ESG scores are associated with superior (inferior) credit ratings, which is known to decrease (increase) beta. In order to investigate the marginal effect of ESG scores, we construct quintile-based portfolios with similar characteristics along the three major dimensions that affect a bond’s risk and return profile, namely its credit rating, the issuer’s industry and the time to maturity (or call). After equalising the industry, tenor and rating composition of the five portfolios, we find that ESG factors do not significantly contribute to positive alpha in the bond market. In fact, the best social quintile portfolio has statistically significant negative alpha; though given the non-monotonicity of the results and the multiple applications of confidence interval tests without multiplicity adjustments, we cannot conclude in favour or detriment to ESG effects on alpha. More importantly, however, once we adjust for credit rating and industry factors, we find that the previously observed beta-reduction benefits of ESG factors are no longer significant. In fact, the best environment and social quintiles have significantly higher beta, which is undesirable. In addition, better total ESG quintiles have betas that are nearly monotonically increasing and almost significant, which is again, undesirable. While ESG factor analysis is an important part of any investment process, participants need to understand the strengths and weaknesses of ESG scores. Future research should continue to explore these relationships as ESG measurement techniques improve.