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17 feb 2020

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 which 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 


Historical credit spread for Investment Grade and High Yield bonds

Chart 1

Source: Lyxor International Asset Management, Bloomberg, data as at 31/01/2020
Past performance is not a reliable indicator of future returns. 



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 years1.         

Default rate for high yield bonds

Chart 2

Source: Lyxor International Asset Management, Moody’s, data as at November 2019
Past performance is not an indicator of future returns.

1 Moody’s Investor Services Default trends – Global, 30 January 2020

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.

Exposure to the energy sector for ESG and Broad High Yield indices 

Chart 3

Source: Lyxor International Asset Management, Bloomberg Barclays. Data as at October 2019
Past performance is not an indicator of future returns. 

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 which 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. 

Chart 4

*The first score (3.6) is computed by giving a score of 0 to the non-rated portion of the benchmark, while the second (4.2) is the score of the rated portion alone.
Source: Lyxor International Asset Management, Bloomberg Barclays, data as at 04/02/2020
Past performance is not an indicator of future returns.


Protecting value during times of stress

To analyse 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.  

chart 5

Sources: Lyxor International Asset Management, Bloomberg Barclays, MSCI. Data as at 10/02/2020. Reported returns from 30/09/2018 to 31/12/2018. Past performance is not an indicator of future returns. 

This analysis leads us to conclude that restricting high-yield credit indices to those firms with the highest ESG scores could result in more consistent performance over time. 

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.  

Risk Warning

This document is for the exclusive use of investors acting on their own account and categorised either as “Eligible Counterparties” or “Professional Clients” within the meaning of Markets in Financial Instruments Directive 2014/65/EU. These products comply with the UCITS Directive (2009/65/EC). Société Générale and Lyxor International Asset Management (LIAM) recommend that investors read carefully the “investment risks” section of the product’s documentation (prospectus and KIID). The prospectus and KIID are available free of charge on www.lyxoretf.com, and upon request to client-services-etf@lyxor.com.

Except for the United-Kingdom, where this communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorized and regulated by the Financial Conduct Authority in the UK under Registration Number 435658, this communication is issued by Lyxor International Asset Management (LIAM), a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/EU) and AIFM (2011/61/EU) Directives. Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority).

The products mentioned are the object of market-making contracts, the purpose of which is to ensure the liquidity of the products on the London Stock Exchange, assuming normal market conditions and normally functioning computer systems. Units of a specific UCITS ETF managed by an asset manager and purchased on the secondary market cannot usually be sold directly back to the asset manager itself. Investors must buy and sell units on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units and may receive less than the current net asset value when selling them. Updated composition of the product’s investment portfolio is available on www.lyxoretf.com. In addition, the indicative net asset value is published on the Reuters and Bloomberg pages of the product, and might also be mentioned on the websites of the stock exchanges where the product is listed.

Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice. It is each investor’s responsibility to ascertain that it is authorised to subscribe, or invest into this product. This document is of a commercial nature and not of a regulatory nature. This material is of a commercial nature and not a regulatory nature. This document does not constitute an offer, or an invitation to make an offer, from Société Générale, Lyxor Asset Management (together with its affiliates, Lyxor AM) or any of their respective subsidiaries to purchase or sell the product referred to herein.

Research disclaimer

Lyxor International Asset Management (“LIAM”) or its employees may have or maintain business relationships with companies covered in its research reports. As a result, investors should be aware that LIAM and its employees may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see appendix at the end of this report for the analyst(s) certification(s), important disclosures and disclaimers. Alternatively, visit our global research disclosure website www.lyxoretf.com/compliance.

Conflicts of interest 

This research contains the views, opinions and recommendations of Lyxor International Asset Management (“LIAM”) Cross Asset and ETF research analysts and/or strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental Cross Asset and ETF Research opinions and recommendations contained in Cross Asset and ETF Research sector or company research reports and from the views and opinions of other departments of LIAM and its affiliates. Lyxor Cross Asset and ETF research analysts and/or strategists routinely consult with LIAM sales and portfolio management personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of ETFs tracking equity, fixed income and commodity indices. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. Lyxor has mandatory research policies and procedures that are reasonably designed to (i) ensure that purported facts in research reports are based on reliable information and (ii) to prevent improper selective or tiered dissemination of research reports. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, competitive factors and LIAM’s total revenues including revenues from management fees and investment advisory fees and distribution fees.

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