Investors in "Green" Bonds Face Lower Returns

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.