The impact of CSR on credit risk

By LARRY SWEDROE

The research into the effect of sustainable investment strategies on corporate bond portfolios (including the 2020 study Primary Corporate Bond Markets and Social Responsibility and the 2021 studies Does a Company’s Environmental Performance Influence Its Price of Debt Capital? Evidence from the Bond Market, ESG Screening in the Fixed-Income Universe and How ESG Affected Corporate Credit Risk and Performance) has found that not only do high environmental, social and governance (ESG) scores lead to lower corporate bond spreads, they also lead to lower exposure to systematic volatility, lower levels of idiosyncratic risk (less likelihood of suffering from issuer-specific risks), less exposure to the credit factor, and reduced tail risk. The research has also found that after adjusting for credit quality, the higher-ESG-rated issuers still had lower spreads compared to the lower-ESG-rated issuers.

The research (such as the 2021 study Dynamic ESG Equilibrium) has found the same impact on equities — higher ESG scores lead to higher valuations. Thus, a corporation’s focus on sustainable investment principles leads to a lower cost of capital, providing them with a competitive advantage.

We turn now to reviewing the findings of two papers published in the January 2022 issue of Finance Research Letters.

New evidence

Christina Bannier, Yannik Bofinger and Björn Rock contribute to the sustainable investing literature with their study Corporate Social Responsibility and Credit Risk, in which they examined the association between corporate social responsibility (CSR) and various measures of credit risk (credit default swap spreads, probabilities of default, distance to default and credit ratings) for U.S. and European firms over the period 2003-2018. They considered the scores of the individual environmental, social and governance pillars from the Thomson Reuters database (formerly ASSET4) in isolation as their main explanatory variables. Following is a summary of their findings:

European companies exhibited much better environmental and social scores than U.S. firms. Though the difference with respect to the governance pillar was much smaller, it was still significant.
Stronger environmental activity was correlated with lower market-based credit risk for both European and U.S. firms.
While European firms’ credit ratings improved with stronger governance-related activities, governance risk was already fully reflected in the credit rating.
U.S. firms reduced credit risk only due to stronger environmental activities, whereas European firms displayed lower credit risk due to environmental, social and governance activities.

Their findings led Bannier, Bofinger and Rock to conclude that “not all sustainability elements are equally relevant when comparing U.S. and European firms.” They also noted that credit ratings do not fully reflect a firm’s CSR activities. We turn now to the second study.

Trung Do contributes to the sustainable investing literature with his study Corporate Social Responsibility and Default Risk: International Evidence, in which he investigated the relationship between CSR and default risk in 36 countries between 2002 and 2016 with a focus on the differential effect conditional on the lengths of time horizons. His data sample contained 28,439 firm-year observations for 2,934 unique firms. He used Thomson Reuters to construct a firm-level CSR performance and data from Credit Research Initiative (CRI) to measure multi-period default probability with different term structures (from one month to five years). Following is a summary of his findings:

The average CSR scores increased from 47.5 in 2002 to 54.9 in 2016 — consistent with the growing attention to CSR by stakeholders.
CSR is negatively associated with the probability of default, and the effect is stronger in the long term than in the short run — a one-standard-deviation increase in CSR score was associated with a reduction of 0.2 basis points in the one-month CRI probability of default, and increased to about 10.4 and 15.9 basis points, respectively, for three- and five-year CRI horizons. The data was significant at the 1 percent confidence level.
The negative correlation between CSR and default risk is more pronounced in countries with weaker market-supporting institutions.
The benefits of CSR investment are greater in countries with weaker capital markets and legal institutions, and where transaction costs are higher and access to capital markets is limited.

His findings led Do to conclude: “Our research provides empirical evidence that suggest policy makers continue encouraging firms to adopt socially responsible behavior since it comes with less financial bankruptcies, and stronger and more stable economies. For managers, this study shows that there is an economic benefit for firms that are socially responsible. CSR enables them to reduce transaction costs, improve access to resources, and enhance competitive advantages, which in turn lower default probability.”

Investor takeaways

The empirical research on sustainable investment strategies has persistently found that ESG risks are not fully reflected in corporate credit ratings. Perhaps in response to the research findings, 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 E and S scores. Fitch, the third leading rating agency, joined Moody’s and S&P in taking ESG dimensions into account in 2017, resulting in a reduction in the incremental credit risk information provided by ESG scores. There is, however, an alternative explanation — the lower credit spreads of firms with high ESG scores could reflect a preference by investors for high-ESG-rated issuers (investors willing to accept lower returns as a trade-off for expressing their values).

For those desiring to express their values through their investments, there is another important takeaway. As noted, the empirical research shows that high ESG scores lead to both higher equity valuations and lower corporate 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. It also provides companies with 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.

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