Credit ratings for bond issues have been a mainstay of fixed income analysis for well over 100 years. The two big Nationally Recognized Statistical Ratings Organizations (NRSRO), Moody’s and Standard & Poor’s, have well-defined thresholds for placing issuers into their respective ratings buckets. For example, an industrial company has to maintain leverage (debt/EBITDA) below 2x to sustain a single-A rating. However, beyond the quantitative thresholds, Moody’s states that they “consider all information known and believed to be relevant… that the analyst and rating committee find credible and potentially significant to a rating decision.” Qualitative factors may include scale, diversification, industry structure, and management’s financial policy.
In practice, rating agencies are occasionally lenient even when credit metrics do not support current ratings, e.g., if there is a stated commitment and credible plan from management to improve financial metrics. As an example, there is a large aerospace company that currently has a leverage ratio which is well above what is typical for investment grade (IG) ratings. However, the company is expected to produce positive free cash flow in 2022 and begin paying down debt to bring credit metrics back in line with IG levels. With this prospect and a nod to their scale and essentiality, they remain IG rated.
With the long history of NRSRO analysis and the plethora of credit analysts, there is generally significant agreement on an appropriate credit rating. In fact, a recent JP Morgan study showed that for investment-grade issuers (excluding emerging market issuers), the two big rating agencies agree on the letter category rating 78% of the time and less than 1% of ratings differ by more than one letter grade
Environmental, Social, Governance (ESG) ratings, on the other hand, lack the longstanding history and industry consistency. Yet, ESG ratings influence material factors in the market, such as Key Performance Indicators (KPIs) to sustainability-linked bonds (SLBs), determiners of indices, C-suite compensation, companies’ cost of capital and reputation. The ESG industry is continuing to grow and is expected to reach valuations of $5 billion by 2025. A handful of major players representing leading credit rating agencies and index providers now dominate the ESG ratings market, a sign that ESG is becoming embedded in the financial markets. Both Moody’s and S&P have purchased providers of ESG data that produce ESG risk assessment scores that can impact credit ratings. Separately, the SEC recently commented that with NRSROs considering ESG factors, there may be conflicts of interest, and they need to be careful not to deviate from long-standing credit rating methodologies.
In contrast to the general agreement on credit ratings, the above-mentioned JP Morgan study showed that across MSCI and S&P, ESG ratings agreed only 18% of the time. Our analysts did a similar internal study analyzing investment-grade senior debt in the Bloomberg Corporate Index assessed by MSCI, Sustainalytics, and S&P Global ESG Rank (formerly RobecoSAM). When analyzed across normalized ESG ratings buckets, MSCI ratings agreed with Sustainalytics 19% of the time and the S&P Global ESG Rank 27% of the time, while Sustainalytics assessments agreed with the S&P Global ESG Rank only 16% of the time.
One reason for the large discrepancy among ESG ratings? The lack of standardized methodologies among providers, particularly in how they define and measure E, S and G factors for a given industry or issuer. In other words, not all rating agencies choose the same “key issues” when defining E, S, and G, and even more so, define those key issues with different indicators and data inputs.
Another reason ESG ratings may differ is data availability, transparency, and integrity. There is far less reliable and consistent E, S, and G related data available for issuers. For example, emissions data often lags by a year or more, social-related data can be inconsistent due to varying regulatory standards by geography, and company reporting can be patchy depending on the size and resources of issuers. Unlike the credit ratings agencies, the ESG rating providers’ analysts do not have the same access to non-public information as the traditional NRSRO credit analysts who meet routinely with management teams and carefully consider the issuer’s strategy, financial policies, and ratings ambitions. We often hear from our issuers how disconnected the ESG providers are from management plans, actions, and strategies.
The market hasn’t really scratched the surface of ESG inconsistencies, given there are other asset classes that are even more in their infancy vis-à-vis ESG, such as securitized and municipal assets. For instance, should ABS be analyzed independently of the parent/sponsor because they are bankruptcy remote, or should there be a parental overlay given management views, previous controversies, and potential support? In addition, relying solely on third-party providers may result in incongruent portfolio positioning; there are several cases where passive ESG funds hold positions in laggards either due to a rating disagreement or when the overall portfolio “score” is within bounds. It is also noteworthy that merely applying third-party ESG ratings to passive, ESG index-based portfolios or positively-tilted portfolios may result in some sector biases, such as Financial, Technology, and Capital Goods overweights versus Energy, Tobacco, and Basic Materials underweights.
The ultimate goal of ESG ratings – like credit ratings – is to allow investors to accurately price ESG-related risks and opportunities. Improved data disclosure, standardized methodologies and transparency could go a long way towards developing more mature, reliable ESG ratings. However, with the general lack of longstanding history and consistency in the market today, ESG analysis truly calls for diligence and a robust research process. At IR+M, we would rather have our credit analysts conduct fundamentally integrated analysis that includes material ESG risks to credit – who better than a “subject matter expert” to decide what is important to bond selection? Within our credit research process, our analysts review third-party key issues, scores, weightings, and ratings, much like we review Moody’s and S&P, but we ultimately come to our own conclusions. As an active manager, our Research Analysts play a pivotal role in our investment process. ESG data only goes so far –the magic happens when it’s uniquely analyzed and applied in meaningful ways.
Sources: As of 2/24/22. IR+M internal analyst study data as of 1/25/21. The Journal of Portfolio Management as of 11/1/21 (https://jpm.pm-research.com/content/iijpormgmt/48/1/local/complete-issue.pdf). The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research + Management. Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by IR+M. Bloomberg is not affiliated with IR+M, and Bloomberg does not approve, endorse, review, or recommend the products described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any IR+M product.