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.
Following is a summary of their findings:
- There was an economically trivial difference in yield (and spread) between green and non-green bonds of approximately 0.45 basis points (indicating a slight green bond discount).
- In approximately 85% of matched cases, the differential yield was exactly zero. In addition, among the remaining 15% of securities, approximately 40% implied a negative differential (or a green bond premium), while the other 60% implied a positive differential (a green bond discount). And there is no theory suggesting green bonds should trade at a discount.
- There was no relationship between issuance size and estimated premiums.
- There was no meaningful association between green and non-green bonds and market liquidity.
- Greenwashing – the process of conveying a false impression or providing misleading information about the environmental soundness of a company's products – was found not to be a cause of the lack of a meaningful association between green and non-green bonds and market liquidity.
- The underwriting cost charged for issuing green bonds was about 10% higher than for almost identical non-green bonds. However, in 70% of cases, the differentials were precisely zero, indicating that in most situations underwriters tend to view these securities as identical.
- Green issuances did help to somewhat broaden the issuers’ investors base – green issues had 12 to 20% less ownership concentration.
- Green bonds are, on average, approximately one notch higher in credit quality, which may reflect wealthier municipalities’ preferences towards environmental sustainability.
Their findings led Larcker and Watts to conclude that their results “provide strong evidence that investors are unwilling to sacrifice returns to support environmentally friendly projects, and thus the greenium is equal to zero.” They added that, at least in the municipal bond market, the evidence suggests that investor nonpecuniary preferences are unlikely to drive the asset pricing differentials found in some of the prior literature. However, they did add that while “a greenium does not currently exist, as the market matures and gains momentum a greenium may emerge.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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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.
