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?