ESG Screening in the Fixed-Income Universe

Abstract

This paper evaluates the impact of a screening process based on Environment, Social, and Governance (ESG) scores for an otherwise passive portfolio of investment-grade corporate bonds. The main result is that this filtering leads to a substantial improvement of the targeted ESG score without reducing the risk-adjusted performance but with significant biases in regional, sectoral, and risk factor exposures. We find that screening is very often associated with a substantial improvement in the risk profile. In particular, ESG-tilted portfolios lead to large negative exposure (i.e., protection) to credit risk. Screening based on the Environment score is where most of the reduction in risk takes place, making this criterion particularly relevant in moving the portfolio toward a more defensive composition. We demonstrate that screening at the regional and sectoral levels allows investors to eliminate undesirable regional and sectoral exposures while delivering similar ESG scores and risk-adjusted performances.

Keywords: Corporate bonds, ESG investing, Portfolio construction, Bond risk factors

JEL Classification: G11, G24, M14, Q01