Theory predicts and research has shown that positive environmental, sustainability and governance (ESG) scores correlate with a lower cost of capital for companies, lowering the expected return on stocks. New research shows a similar effect in the bond market, with positive ESG scores correlated to smaller credit spreads, decreasing the yield to investors.
Companies with low ESG (environmental, social and governance) ratings have a relatively small investor base (fewer investors) because of investor preferences (many risk-averse investors and socially conscious investors avoid exposure to low-ESG-ranked companies) and information asymmetry (the problem of asymmetric information between companies and their investors is less severe for high ESG-rated companies because they are typically more transparent, in particular with respect to their risk exposures and their risk management and governance standards). The smaller base, along with the perceived increased risk, leads to lower valuations and thus a higher cost of capital. The reverse is true for companies with high ESG ratings: The larger investor base, combined with the perceived reduced risk, leads to higher valuations and thus a lower cost of capital.
The findings from academic research, such as the 2019 paper, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance,” are consistent with the theory. The authors found that the valuation channel is governed by a firm’s exposure to systematic risk. High-ESG-scoring firms have less exposure to market shocks and exhibited lower recent five-year volatility of earnings when compared to low-scoring firms. Thus, they have lower betas. The lower betas result in higher valuations (such as lower book-to-market and higher price-to-earnings ratios), producing lower costs of capital.
Do we see the same effect in the bond market?
Evidence from the bond market
Michael Halling, Jin Yu and Josef Zechner contribute to the ESG literature with their August 2020 study, “Primary Corporate Bond Markets and Social Responsibility.” They began by noting that the “primary bond markets represent a setting in which expected risk premia can be quantified via observed spreads over a riskless reference rate. Primary markets have the additional advantage that offering prices are usually intermediated by investment banks, which should ensure that corporate bonds can be issued at a fair spread which is less likely to be influenced by temporary market (il)liquidity levels, which seems to be the case in secondary bond markets. At the issue stage, bonds generally also have a recent credit risk rating, which effectively controls for many issuer and bond characteristics.” Their data sample covered 5,261 U.S. bond issues from 2002 to 2020. Their analysis focused on the first two ESG components: E and S. Following is a summary of their findings:
- There is a robust negative relation between E and S ratings and issue spreads in the corporate bond primary market – even when controlling for bond ratings and various firm characteristics, such as net book leverage, size, industry and profitability. Good ES performance is rewarded in primary bond markets by lower credit spreads.
- 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. However, the employee-related score significantly reduces corporate bonds spreads even for highly rated issues.
- The ESG score effect is strongest for firms in manufacturing, agriculture, mining and construction.
- Slightly more than 60% of the sample observations came from ES-good firms. Those bond issues pay significantly lower spreads (difference of 45 bps).
- Not all ES dimensions are equally important, as the above results were driven mostly by the product-related dimension and to a lesser extent by the employee-related dimension – other dimensions such as environment, community or human rights, which get more attention in the media and by policymakers, do not seem to matter for the pricing of corporate bonds.
- Environment-related aspects only seem to matter for those industries with largest exposure to environmental risks.
- During expansions, a high score on employee relations has a significantly negative effect on spreads in the primary market – firms with high scores on employee relations seem to have a comparative advantage in expansions, which are usually characterized by tighter labor markets. During recessions, the coefficient on employee relations loses its significance.
An interesting observation is that the authors 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 they would take ESG dimensions more explicitly into consideration when determining credit ratings, thereby reducing the information content in the respective ES scores. Fitch, the third leading rating agency, joined Moody’s and S&P in taking ESG dimensions into account in 2017. 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.”
Summary
The evidence shows that high ESG scores lead to both higher equity valuations and lower bond spreads. Thus, we can conclude that a focus on sustainable investment principles leads to lower costs of capital, providing companies with a competitive advantage and thus 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. In addition, the ESG research, including the 2020 study, “Corporate Sustainability and Stock Returns: Evidence from Employee Satisfaction,” has found that improving ESG scores also improves employee satisfaction. This is consistent with the finding by Halling, Yu and Zechner that during business-cycle expansions a high score on employee relations has a significantly negative effect on spreads in the primary market – firms with high scores on employee relations seem to have a comparative advantage in expansions, which are usually characterized by tighter labor markets.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time without notice. Certain third-party information is based upon 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 authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-27
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Theory predicts and research has shown that positive environmental, sustainability and governance (ESG) scores correlate with a lower cost of capital for companies, lowering the expected return on stocks. New research shows a similar effect in the bond market, with positive ESG scores correlated to smaller credit spreads, decreasing the yield to investors.
