SINGAPORE (Apr 24): Covid-19’s market impact has not only led to losses in equities (the MSCI ACWI Index demonstrated a –21.3% performance for 1Q2020) but also to extreme levels of volatility among investment-grade corporate bonds as investors fled to cash. Major investment-grade fixed-income ETFs experienced price discounts of up to 6% to their reported net asset value (NAV), a level not seen since 2008. The one month at-the-money (ATM) implied volatility of the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) (see chart 1) peaked at 63.4% on March 19 before the Federal Reserve (the Fed) announced it would buy investment-grade corporate bonds, including ETFs linked to that market. By the end of the quarter, one month implied volatility fell to 26.4% but implied volatility remained elevated.
The MSCI USD Investment Grade (IG) Corporate Bond Index returned –2.50% over 1Q2020, though that doesn’t tell the whole story. It plots the duration-weighted option-adjusted spread (OAS) of the index on the left and the cumulative total returns and excess returns on the right. The index spread was at relatively tight levels of 107 basis points (bps) as of Dec 31 last year but started widening on Feb 19 as Covid-19 spread. To counter the anticipated economic slowdown, the Fed cut the benchmark interest rate by 50 bps on March 3. However, it was not until March 23 — when the Fed pledged to buy government bonds in unlimited amounts, and to purchase investment-grade corporate bonds and provide liquidity to the market — that the OAS started to ease from its peak of 338 bps, slipping to 246 bps at the end of the quarter.
Factor and ESG indexes – Q1 performance
Throughout the first quarter of 2020, investors grappled with the financial implications that contagion risks could have on corporate balance sheets, cash flows, profitability and — even more critically — business continuity.
The performance of corporate bond factor-tilt indexes and ESG indexes. Defensive factors characterized by issuers with shorter durations and stronger balance sheets fared relatively better — perhaps due to investors’ confidence in their ability to withstand supply and demand disruptions during the widespread lockdown.
Among credit style factors, the low-risk factor outperformed by 0.42% based on total returns and 3.28% on excess returns, compared to the 1.69% and 1.77% outperformance of the quality factor. Carry defined by bonds with relatively high OAS, experienced the largest drawdown, while the value factor, calculated as the residual spread not explained by other factors, was relatively muted. Issuers with higher MSCI ESG Ratings also outperformed the broad market. The MSCI USD IG ESG Leaders Corporate Bond Index, using best-in-class rating selection, outperformed its parent index, the MSCI USD Investment Grade Corporate Bond Index, by 0.75% and 1.29% total and excess returns, respectively.
Performance of corporate bonds with weak and/or deteriorating ESG ratings
To see how corporate-bond performance corresponded with ESG ratings, we plotted the total and excess returns of the MSCI USD Investment Grade Corporate Bond Index universe based on the underlying issuer’s MSCI ESG Rating. The highest ESG-rated issuers outperformed the weakest ESG rated issuers (the two categories are weighted by market value of the outstanding bonds).
While ESG ratings reflect the current assessment of an issuer, ESG ratings trends reflect how the ratings have changed over the last 12 months. We also replicated the return analysis on issuers with a positive ESG trend (improvement in ESG ratings), neutral (unchanged ESG ratings) and a negative ESG trend (deterioration in ESG rating). We found that issuers with positive ESG trends outperformed those with negative ESG trends in 1Q2020, with most of the performance differential attributed to issuers with negative ESG trends.
Performance of corporate bonds across sectors
To see how corporate bonds performed across sectors, we also plotted the total and excess returns, relative to the universe, of the MSCI USD Investment Grade Corporate Bond Index universe based on the underlying issuer’s Global Industry Classification Standard (GICS) sector (see chart 2). On March 8, the start of a price war between Saudi Arabia and Russia triggered a collapse in the price of US oil (WTI Crude fell 67% during 1Q2020) and contributed to energy being the worst-performing sector in 1Q2020. Over the same period, information technology and healthcare emerged as the best performing sectors.
ESG leaders’ overall performance
It is important to note that MSCI ESG Ratings are designed to be sector neutral, with an aim of preventing the universe from being dominated by issuers with higher ESG ratings in certain sectors — like technology or healthcare — or that issuers with lower ESG ratings being predominantly from other sectors such as energy. This was particularly relevant in the context of the collapse in oil prices during this period that weighed on the energy sector.
In addition, we plotted the relative performance of each GICS sector in the MSCI USD IG ESG Leaders Corporate Bond Index with respect to the corresponding sector in the parent index, the MSCI USD IG Corporate Bond Index, in 1Q2020. We focused our attention solely on ESG Leaders, given its higher active risk stemming from issuer selection, although a similar pattern was observed for ESG Universal. Among the 11 sectors, nine of the ESG leaders sectors outperformed the parent index on an excess returns basis.
Longer historical perspective
Defensive-factor and ESG indexes outperformed their parent indexes on an excess-returns basis over the one, three and five year period ended March 31 though results were less consistent when we examined total returns, largely due to duration biases. Overall, dissecting corporate-bond performance over the first quarter of 2020 using factors and ESG ratings provided insight into fixed-income performance during stressed market conditions. This adds to our existing research examining ESG exposure and defensive characteristics such as systematic risk, idiosyncratic risk and profitability and our work on factors and corporate bonds.
E Hitendra D Varsani is the executive director of equity core research while Rohit Mendiratta is the senior associate of data science research at MSCI.
