There is no “Green Premium” in the Municipal Bond Market

A prominent fear facing investors with an environmental, social and governance- (ESG-) based mandate is whether they must sacrifice returns to achieve their goals. New research shows that ESG-based municipal bonds deliver the same returns as those without a “green” mandate.

With the tremendous increase in investor cash flows, ESG measurement, corporate social responsibility (CSR) activities and socially responsible investing (SRI) are increasingly important research topics among academics and professionals. Much of the research focuses on the question of whether investors are willing to give up financial benefits to invest in environmentally friendly or socially responsible assets.

David Larcker and Edward Watts contribute to the sustainable investing literature with their paper, “Where’s the Greenium,” published in the April-May 2020 issue of the Journal of Accounting and Economics. Their study focused on the U.S. municipal bond market because green bonds offer the same credit protections as their non-green counterparts. The only difference between the two is that the proceeds from the sale of green bonds are allocated to fund “environmentally friendly projects” (such as sustainable water management and energy production). Thus, any differences in security pricing can be attributed to investor preferences for nonmonetary security features rather than differences in expectations about future cash flows or risk.

Another benefit of using munis was that the average issuance size of U.S. municipal bonds is only about $5 million versus about $400 million for corporate bonds. The authors noted: “Since the size of green issues is small, there is ample opportunity for green investors to be the marginal trader, which would not be the case for very large green issues in a market setting where green investors do not have the capacity to buy most of the offering. This means that investors with utility for green investments and the willingness to trade off bond yield for green use of funds are likely to be the marginal trader setting the price of the bond. Thus, there are strong reasons to believe that our setting is one where we are most likely to find a greenium (if it actually exists).” Their data sample consisted of 640 matched pairs of green and non-green issues issued on the same day, with identical maturity and rating, and issued by the same municipality over the period June 2013 through July 2018.