ESG Investors Succeed in the Bond Market
New research on corporate bonds shows that investors driven by environmental, social and governance (ESG) mandates have reduced the cost of capital for “green” companies – thereby achieving their goal of addressing concerns around climate change.
Concerns over global warming and the economic risks of climate change have drawn increasing attention from not only equity investors but bond investors as well. Consider the following examples:
- AXA, a giant multinational insurance firm managing $790 billion in assets, now avoids portfolios with global warming potential by shifting away from heavy polluters.
- Wells Fargo Asset Management launched a climate transition credit strategy in June 2021 with the intention to decarbonize their fixed-income portfolios.
- State Street Global Advisors launched the State Street Sustainable Climate Bond Funds in June 2021 with the aim of significantly reducing investors’ exposure to carbon emissions.
- The Bank of England committed in May 2021 to use its $28 billion of corporate bond holdings to nudge companies to cut greenhouse gas emissions faster.
Jie Cao, Yi Li, Xintong Zhan, Weiming Zhang and Linyu Zhou contribute to the sustainable investing literature with their July 2021 study, “Carbon Emissions, Institutional Trading, and the Liquidity of Corporate Bonds,” in which they investigated how firms’ carbon emission levels affect institutional investors’ trading behaviors and liquidity conditions of corporate bonds. They began by noting that relative to the equity market, the corporate bond market is less liquid, has higher transactions costs and is more dominated by institutional investors. In addition, “the over-the-counter nature of the corporate bond market renders it heavily reliant on dealer intermediation … and institutional investors are much more likely to trade in herds in the corporate bond market. Should institutional investors of corporate bonds react to concerns for carbon emissions, the impact would be reflected in both their trading patterns and market liquidity.”
Their data sample covered 28,701 unique corporate bonds from 1,274 unique U.S. public issuers over the period January 2007 to December 2019 and represented 57% of the corporate bond market. Causality was further established by exploiting two shocks: the Paris Agreement (December 2015) and the election of U.S. President Trump (November 2016). Firms’ carbon emission scores were from their MSCI ESG rating. They focused on mutual funds and insurance companies, as they are the major participants in the corporate bond market. Following is a summary of their findings:
- Both mutual funds and insurance companies are more likely to sell corporate bonds in herds if the bonds’ issuing firms have higher carbon emissions.
- Mutual fund flows negatively respond to the fund’s carbon exposures.
- Bond mutual fund managers have the incentive to dump the high-carbon bonds to attract flows and avoid redemptions, leading to potentially higher selling pressure on the high-carbon bonds.
- Mutual funds are more likely to sell high-carbon bonds in the face of investor redemptions.
- Bonds issued by high-emission firms experience worse liquidity conditions.
- Institutional investors’ sell-herding levels toward bonds with high-emission issuers greatly intensified after the Paris Agreement and lessened following the Trump election.
Their findings led the authors to conclude that end investors of corporate bond mutual funds are sophisticated enough to take into account the fund’s exposures to carbon emissions. The result is that carbon emissions affect mutual funds’ trading decisions. They added that “constraints faced by institutional investors can amplify shocks for underlying markets. For mutual funds, we find that when facing investor redemptions, funds tend to sell more high-emission bonds. For insurance companies, we find that they are more likely to sell high-emission bonds with higher risks of becoming ‘fallen angels’, likely driven by their capital constraints.” These effects become amplified during times of market stress.
Corporate bond investors should also be aware of the evidence on sustainable investing’s impact. For example, the authors of the 2020 study, “Primary Corporate Bond Markets and Social Responsibility,” found that there is a robust negative relation between environmental (E) and social (S) ratings and issue spreads in the corporate bond primary market and that the effect is strongest for low-rated bonds; for highly rated issuers (i.e., AAA or AA), the aggregate E and S score is insignificant. An interesting observation is that the authors found the explanatory power for spreads had 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. The authors hypothesized that their “results suggest that ratings do not fully subsume all the effects of ESG scores on credit spreads.” They concluded: “Our evidence suggests that some ES-dimensions capture information that is relevant for default risk.”
Summarizing, the evidence shows that high ESG scores lead to lower corporate bond spreads as well as higher equity valuations. Thus, we can conclude that 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 the 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.
Important Disclosure: The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-124