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Fallen Angels with ESG Wings

This study examines the effect of environment, social, and governance (ESG) factors on fallen angel (FA) bonds, which are rated investment grade at issue but are subsequently downgraded to high yield. FAs are characterized by price pressure, higher yields, lower coupons, weaker covenants, higher probability of bankruptcy, higher durations, and higher concentration in sectors subject to a recent specific shock as compared with high-yield bonds. The authors show that the ESG-tilted FA portfolio negates some of the negative characteristics and increases the risk-adjusted return of the portfolio. The authors also examine the effect of the separate components of ESG—environmental (E), social (S), and governance (G)—separately on portfolio performance. They find that the impact of a governance-tilted portfolio has better risk-adjusted return than the other two components during the period of analysis. The conclusions are relevant for both active and passive institutional investors in constructing investment-grade as well as high-yield strategies. TOPICS: Fixed income and structured finance, ESG investing, fixed-income portfolio management Key Findings • Environment, social, and governance (ESG) scores can be used in the construction of fallen angel portfolios to negate their negative characteristics and also provide higher risk-adjusted returns. • A governance-tilted portfolio has better risk-adjusted return as compared to other two components of ESG. • ESG scores can be used as a yardstick to differentiate securities while liquidating the fallen angels in the investment-grade index at the time of rebalancing.