ESG opinions are affecting the shape of bank spread curves
When bank bond issuers face ESG risks such as climate change, this should be translated in the market through significant pick-up on longer maturities. Based on that, we use the ValueCo ESG opinions to assess where banks stand with regards to such risks. Our analysis indeed reveals a relation between such opinions and the steepness in the curve, but that relationship is more clear when we purely focus on the environmental part of such opinion.
The market should reflect on significant pick-up on longer maturities when bank bond issuers face ESG risks such as climate change
We use the ValueCo E opinion, as this reflects the consensus of the buyside on where the bank stands with regards to such risks
Our small sample indeed reveals a relation between such opinions and the steepness in the curve when we purely focus on the environmental part of such opinion
A while ago we released an introduction note related to our new research partnership with ValueCo, a data provider which specializes in collection ESG opinions from the buy-side and standardizing these. In this note (see ), we, amongst others, showed the statistical relevance of the ValueCo ESG consensus opinion on broad market credit spreads. But could such relevance also be visible in the relationship between short maturity bond spreads and long maturity bond spreads? This relationship is also known as curve steepness.
The economic thought behind higher steepness on weakly positioned issuers is that transition or adaptation requirements will have low importance in the short-term investment horizon, for example because governments are still in the process of deciding how the desired energy transition to meet climate ambitions is set to take shape. As such, a debt holder can be comfortable that the effects on issuers in the short maturities from for example climate change could be limited. However, such long decision making process by governments is likely to make transition and adaptation back-ended with accordingly more pressure to reduce energy intensity and emissions in a short time period. Such pressure or intensity of change is bound to drive uncertainty at investor level on longer dated instruments. Hence, one would expect that issuers with weak ESG credentials to be less prepared for this transition / adaption, and therefore the steepness in their credit curve should be higher than for issuers which benefit from stronger ESG opinions by investors.
We test this assumption by looking at the senior non-preferred (SNP) bank bond space. The issuer would be impacted when its bank loan book suffers from repayment risk because of the underlying borrowers facing high demands regarding climate policy (such as a high carbon cost eroding debt service capacity) or when the borrowers’ productive assets become impaired due to expected climate change. Our bank issuer sample is limited to A2/A3 composite rated SNP / holdco senior instruments given that (1) in this seniority, we were able to draw a sufficient amount of maturities at issuers to measure steepness between short and long (i.e. close to 10y) maturities and (2) the curve for these ratings are close to perfectly aligned at the moment (see chart on the next page on the left), suggesting that we can factor out rating as a driver behind spread level and steepness. This increases our sample to 10 issuers and leaves us purely with the ESG opinion as defining factor behind the pricing and steepness, and we expect that the aforementioned risks of transition/adaption to be captured by the ValueCo issuer opinion data. We use the quantile opinion scores as this better captures differences across the financial sector. For example, two issuers can have a regular score of 60 and 65, yet if the total financial universe has scores in this range, then the first issuer will be qualified as weak and the second one as strong under the quantile approach. We use both the overall ESG opinion and the opinion focused purely on environment to find out which has a bigger effect on curves. The chart below on the right shows that many bank issuers are still perceived as environmentally friendly, and the weakness in the overall ESG score is driven mainly by low scores on governance.
We expect the weaker the ValueCo (i.e. investor) opinion, the steeper the difference between our chosen maturities. To account for overall spread differences in the short maturities, we express steepness relatively, as the pick-up to the long maturity as % of the two year maturity. This avoids the wrong signal one could get from expressing de difference in absolute numbers. For example going from 10bp to 20bp between short and long maturity bond is a 10bp absolute steepness or 100% steepness when expressed relatively, while going from 20bp to 30bp is also a 10bp absolute steepness, but 50% steepness when expressed relatively.
The chart below shows the results of curve steepness when we confront these against the overall bank ESG opinion, but also purely the E opinion. Whilst a close to linear relationship can hardly be found across both examples, we do note that when we focus purely on the E-opinion, the cluster of Barclays, Citibank, Santander, Credit Agricole and Nordea in the right bottom has lower steepness. Admittedly, the BNP and ING curves should also have been flatter ideally, but the shorter maturities in ING and BNP might be priced currently at too tight spread levels given where the rest of the cluster is trading in the two year maturity. HSBC’s flatness has to do with the spread on their 2y bond, being one of the widest spread levels in this sample and it would be right up there with Mizuho when in case the HSBC two year spread would be the same as Mizuho’s. Finally we have also drawn a simple trend-line, but the trend-line in the E-only opinion chart drops nearly three times faster than on the overall ESG-opinion chart. This shows that the E-opinion matters more when it comes to curve steepness on bank bonds. This would also imply that bank governance issues have a bearing on both short and long-term maturities. To some extent this is indeed reflected in the higher spread on two year bonds at HSBC, Citibank and Barclays.
