There has been an explosion in academic research on the impact of implementing environmental, social and governance (ESG) on the risk and returns of equity portfolios. Research on fixed income, which has received less attention, shows that positive ESG scores correlate with lower yield spreads, decreasing future returns for bond investors.

Mohamed Ben Slimane, Eric Brard, Théo Le Guenedal, Thierry Roncalli and Takaya Sekine contribute to the literature on ESG investing with their November 2019 study, “ESG Investing and Fixed Income: It’s Time to Cross the Rubicon.” They examined the euro-denominated universe of corporate bonds from the Intercontinental Exchange Bank of America Merrill Lynch (ICE BofAML) large-cap (investment grade) corporate bond Index on a monthly basis from January 2010 to August 2019. For each bond, they used the total/credit return, the modified duration, the credit spread, the yield-to-maturity and the sector classification provided by the index sponsor. To each issuer, they associated the ESG score provided by Amundi. For each company and each month, they assessed the ESG score and its three components: E (environmental), S (social) and G (governance). These scores were based on the data of four external providers and were normalized by sector. They then split the entire period between two subperiods, 2010-2013 and 2014-2019, and created five quintile portfolios.

ESG’s impact on cost of capital

The most important finding was that there is a relationship between ESG ratings and credit ratings (as we should expect, because credit rating agencies incorporate extra financial risks associated with ESG into their evaluations) – bonds with a good credit rating have a better ESG score than bonds with a bad credit rating. Specifically, they found that on average one unit of the ESG score implied a reduction of 9 basis points (bps) after having neutralized the effects of credit rating, subordination, duration and sector; and the yield-spread difference between a best-in-class and a worst-in-class corporation was equal to 31 bps. When examining the evidence on U.S. investment-grade bonds, they found the relationship is weaker than the one observed for EUR IG corporate bonds. For example, the cost of debt between a best-in-class corporation and a worst-in-class corporation was equal to 15 bps, half of the yield spread difference observed for EUR IG corporate bonds.

This finding is consistent with those of Michael Halling, Jin Yu and Josef Zechner, authors of the August 2020 study, “Primary Corporate Bond Markets and Social Responsibility.” They found that 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. They added that the effect is strongest for low-rated bonds; for highly rated issuers (i.e., AAA or AA), the spread difference based on aggregate E and S score is insignificant. However, the employee-related score significantly reduces corporate bonds spreads, even for highly rated issues.