New research shows that spreads have become smaller for corporate bonds among issuers that focus on environmental, social and governance (ESG) factors. Future returns for those bonds will be reduced, but issuers with good ESG track records will enjoy a lower cost of capital.
Sustainable investing continues to gain in popularity. Economic theory suggests that if a large enough proportion of investors chooses to avoid the stocks and bonds of companies with low (poor) sustainability ratings, their security prices will be depressed. Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional cost of exposure to what they consider offensive companies). The reverse would be true of the securities of companies with high sustainability ratings – their security prices will be elevated, reducing their cost of capital. With this knowledge, investors are positioned to pursue their financial goals in the manner that reflects their values and the costs they are willing to bear to achieve those values.
Micol Chiesa, Ben McEwen and Suborna Barua contribute to the ESG literature with their study, “Does a Company’s Environmental Performance Influence Its Price of Debt Capital? Evidence from the Bond Market,” published in the Spring 2021 issue of The Journal of Impact and ESG Investing. They began by noting that the perceived risk of firms with high ESG scores is lower than that of those with low ESG scores because strong ESG performance helps decrease firm risk by reducing the probability and impact of adverse events (such as environmental costs). Their data set covered the years 2016-2018 and a total of 5,620 corporate bonds: 2,168 in the EU market and 3,092 in the U.S. market.
Following is a summary of their findings:
- Environmental performance is negatively associated with the cost of debt – the lower (worse) the corporate environmental performance, the higher the cost of debt.
- Both the EU and U.S. data showed a negative and statistically significant effect of ESG on the coupon rate. The magnitudes of the effects were statistically significant and large. For example, a one-point increase in corporate environmental performance was associated with a decrease in coupon rates of 0.6% in the EU and 0.5% in the U.S.
- The integration of environmental factors into investment processes and decision-making was apparent along each debt maturity, and the longer the maturity, the greater the impact.
- Assigning bonds specifically to green projects or activities by firms may not necessarily lower the cost of borrowing.
- The impact of ESG scores is greater in sectors with greater environmental materiality.
The above findings are consistent with those of Michael Halling, Jin Yu and Josef Zechner, authors of the 2020 study, “Primary Corporate Bond Markets and Social Responsibility,” who examined the impact of ESG scores on bond markets. Their data sample covered 5,261 U.S. bond issues from 2002 to 2020. Their findings led them to conclude that there is a robust negative relation between E and S ratings and issue spreads in the corporate bond primary market – good ES performance is rewarded in primary bond markets by lower credit spreads. They also found that the effect is strongest for low-rated bonds.
Halling, Yu and Zechner found some evidence that the explanatory power for spreads has decreased in recent years. They hypothesized that an 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 ES scores. In 2017, Fitch (the third leading rating agency) joined Moody’s and S&P in taking ESG dimensions into account. Halling, Yu and Zechner added 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, high ESG scores lead to both higher equity valuations and lower corporate bond spreads. 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. In addition, the lower cost of capital provides incentive for firms to “go green” in terms of new products and services.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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New research shows that spreads have become smaller for corporate bonds among issuers that focus on environmental, social and governance (ESG) factors. Future returns for those bonds will be reduced, but issuers with good ESG track records will enjoy a lower cost of capital.