New research shows that corporate bonds issued by companies with good environmental, social and governance (ESG) practices trade with smaller spreads. That is good for those companies, as it lowers their cost of capital. But it means that investors’ returns will be less than for non-green bonds.
The dramatic increase in the demand for sustainable investments has been accompanied by an increase in the issuance of green bonds by corporations hoping to take advantage of a “greenium” – the reduced yield green investors receive for holding a green bond over its equivalent non-green counterpart. The reduced yield could reflect the price sustainable investors are willing to accept as the cost of expressing their values. It might also reflect a risk premium – it is logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts.
The hypothesis is that companies with high sustainability scores have better risk management and better compliance standards. Their stronger controls lead to fewer extreme events such as environmental disasters, fraud, corruption and litigation (and their negative consequences). The result is a reduction in tail risk in the highest-scoring firms relative to the lowest-scoring firms. The greater tail risk creates a “sin” premium. Research confirms the hypothesis. For example, the authors of the 2019 study, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” found that companies with higher ESG scores are less susceptible to systemic risks, resulting in higher equity valuations.
In their study, “Green Bonds: Shades of Green and Brown,” published in the March 2021 issue of the Journal of Asset Management, Moritz Immel, Britta Hachenberg, Florian Kiesel and Dirk Schiereck analyzed the existence of a green bond premium in corporate bonds. They tested the existence of a green premium and the impact of ESG ratings on bond prices. They also analyzed which of the ESG factors are the main drivers of an ESG premium. Their data set covered 466 fixed-rate corporate bonds with a minimum issuance of $100 million, with both a credit and an MSCI ESG rating issued between January 2007 and October 2019.
Following is a summary of their findings:
- There was a negative green bond premium of 8 to 14 basis points – investors are willing to receive a lower yield to “buy green.”
- Having an ESG rating reduced the spread by 9 to 19 basis points – an ESG rating leads to higher credibility of the company, represented through a more favorable spread when issuing green bonds.
- There is a statistically significant influence of ESG ratings on bond spreads – a one-point increase (scale is 1-10) in the weighted average ESG score leads to a decrease in the spread of 6 to 13 basis points. The smaller spread is due to reduced uncertainty about the bond’s “shade of green” – reducing the information asymmetry between issuer and investor regarding the greenness of the bond and potential greenwashing.
- Separating the ESG rating into E, S and G scores, the results were not driven by the environmental (no correlation) or social (weak correlation) friendliness of the green bond issuer but through the company’s governance score (which was strongly significant) – indicating that trust (the belief that the issuer uses the proceeds in the stated way is more important than the environmental image of the issuer) is crucial to determining spreads.
The above findings are consistent with prior research. For example, Michael Halling, Jin Yu and Josef Zechner, authors of the 2020 study, “Primary Corporate Bond Markets and Social Responsibility,” examined the impact of ESG scores on bond markets and found that there is a robust negative relation between E and S ratings and issue spreads in the corporate bond primary market. An interesting observation is that Halling, Yu and Zechner found some evidence that the explanatory power for spreads has decreased in recent years. They hypothesized that a potential explanation for such a pattern is that in late 2015 Moody’s and S&P announced that they would take ESG dimensions more explicitly into consideration when determining credit ratings, thereby reducing the information content in the respective E and S scores. Fitch (the third leading rating agency) joined Moody’s and S&P in taking ESG dimensions into account in 2017.
Economic theory and the evidence show that high ESG scores lead to lower corporate bond spreads. This is consistent with research showing that higher ESG scores also lead to higher equity valuations. Thus, a focus on sustainable investment principles leads to lower costs of capital, providing companies with a competitive advantage. It also provides companies with the incentive to improve their ESG scores. In other words, through their focus on sustainable investment principles, investors are causing companies to change behavior in a positive manner.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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New research shows that corporate bonds issued by companies with good environmental, social and governance (ESG) practices trade with smaller spreads. That is good for those companies, as it lowers their cost of capital. But it means that investors’ returns will be less than for non-green bonds.