The fleeting ‘greenium’ in ESG bonds

Fixed income yields, sustainability and the COVID-19 turning point

Jamie Gordon

ESG impact seed funding

Companies that score highly on ESG can access debt at a lower cost, according to new research from Bank of Italy economists, however, this ‘greenium’ tends to wax and wane over different geographies and time periods.

The report, titled Issuing bonds during the COVID-19 pandemic: Is there an ESG premium?, found a “statistically and economically significant” negative correlation between corporate issuers with higher ESG ratings and lower asset swap spreads on bond issuance during peak pandemic volatility in 2020. Essentially, investors were willing to accept lower yields when investing in the debt of more virtuous companies, meaning they could finance their activities more cheaply during market unrest.

A one standard deviation change in the ESG ratings from MSCI, Refinitiv, Robeco and Sustainalytics resulted in a nine to 14 basis point drop in asset swap spreads – equivalent to a 4-7% decrease in yield spread at issuance – with the greatest effect belonging to MSCI ratings.

Notably, creditworthiness remained the most important driver of yield spreads, with a single S&P Global issuer rating increase cutting the yield spread between 65 and 77 basis points (bps) on average. However, researchers said this was unsurprising given credit risk would naturally be the key factor in pricing new bonds, especially during market turmoil.

Why the premium?

Also, the impact of stronger ESG ratings on asset pricing was far from negligible – and can explained by tangible demand for sustainable investments, in certain conditions. This trend “remarkably accelerated” during COVID-19, with new product launches and even central banks allocating to ESG meaning sustainable allocations made up 36% of global portfolios by the end of 2020, according to the data from the Global Sustainable Investment Alliance (GSIA).

“This shift in investors’ preference is not just a tendency of the industry but it also has important implications in terms of asset pricing, with more sustainable firms benefitting from lower cost of capital,” Fabrizio Ferriani, directorate general for economics, statistics and research, at Bank of Italy, said.

Researchers added this demand came from one of two channels related to double materiality, with some seeking out ESG bonds as a risk management tool to hedge against regulatory, reputational and climate risk while others were happy paying a premium to access debt from companies with a more sustainable footprint.

Interestingly, both types of demand had an impact on asset pricing but to different extents. Risk-based demand – proxied by company emissions intensity and other measures of climate change exposure cited earning calls – had a 15bps impact on yield spreads. Meanwhile, demand based on non-financial factors – proxied by the share of sustainable funds holding corporate bond issuer’s stock – had an impact up to 32bps.

Speaking to ETF Stream, Tom Pughe, fixed income trader at GHCO, agreed ESG-aligned bonds could offer a safety net and enjoy a ‘downturn bid’ alongside traditional safe havens such as gold, US dollars and US Treasuries.

Offering a more technical explanation for ESG bond demand, he added: “Secondary-market trading algorithms are biased to choose ESG-friendly and green bonds when trading at an equivalent adjusted spread.”

He also attributed the ‘greenium’ to “forward-thinking machine learning and portfolio management – specifically real money demand”.

Where the green fairy tale ends

Searching for where the ESG premium faulters, researchers looked at the individual ‘E’, ‘S’ and ‘G’ scores from data providers but found the premium could not be attributed to any one subcomponent alone. Perhaps unsurprisingly, the premium was far more apparent for corporates in developed markets versus emerging ones, where creditworthiness remains the core consideration for yield spreads.

In fact, investors were particularly sensitive to credit risk for emerging market debt, with a single S&P Global credit rating change being twice as impactful versus developed markets, with an asset swap spread difference of more than 100 basis points.

The lack of ‘greenium’ in these regions could owe to several factors, the research said, including lower ESG coverage and disclosure as well as more fragility in emerging markets generally, not to mention the more complex demands of investors in developed markets for securities offering not only good risk-return profiles but also social and climate responsibility. More significant, perhaps, is how the ESG advantage seems to waver depending on market contexts, even in more developed regions.

During the initial COVID-19 shock between mid-February and the end of March 2020, when the Federal Reserve announced its first round of bond market intervention, the yield spread premium of ESG issuers was especially pronounced.

However, the period of gradual rebound between April and June showed “no statistically significant effect” for bond pricing based on changes in ESG ratings for all providers other than MSCI. One explanation for this could be the supply of corporate debt over the first three quarters – including from ESG issuers – hit record volumes, meaning a previously undersupplied entity became commonplace.

Flash forward to today and whether the ‘greenium’ still exists, GHCO’s Pughe said it will have longevity in some form, given investors continue to be ushered towards ESG tendencies by political and social pressures.

However, he added: “We have seen this trend be far less prevalent during this year’s energy crisis. Environmentally better options have been washed out in both international and domestic markets meaning cheaper green-based financing could be downtrend-specific (or uptrend) and more niche than initial assumptions.”

Indeed, Julio Suarez, director of the Association for Financial Markets in Europe (AFME), said the ESG yield premium “marginally widened” from non-existent to up to two basis points by the end of Q1 this year, however, this could perhaps be explained by supply dynamics, with ESG bond and loan issuance down 32% year-on-year during the three-month period.

Interestingly, amid this year’s asset pricing and yield volatility, ESG bond fund assets have proven relatively sticky, with $3.6bn outflows globally during the first five months of the year, versus $242bn for non-ESG fixed income funds, according to data from EPFR Global.

Looking ahead, the ‘greenium’ debate raises some important questions such as whether ESG bonds create different financial outcomes to their vanilla equivalents or how ESG yield spreads will behave as economies continue tackling high inflation and lower productivity.

To what extent a green financing advantage exists, it is vital conflicts of interest and workarounds are eliminated so only truly good corporate actors are included in indices accessing cheaper debt, however fleeting this may be.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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