Aurora Borealis
1 June 2014 CFA Institute Journal Review

The Effects of Corporate Social Performance on the Cost of Corporate Debt and Credit Ratings (Digest Summary)

  1. Vassilis Efthymiou, CFA

A company that is consistently socially responsible should enjoy financial benefits in the form of lower cost of debt resulting from the lower default risk perceived for its borrowing. As a result, the spread of its bond issues should be lower and its credit rating should be higher than those of socially irresponsible firms.

What’s Inside?

The authors are some of the first researchers to examine the relationship between corporate social performance (CSP) and corporate credit risk, as measured by either the spread of corporate bonds or the credit rating assigned to the issuers. Higher levels of CSP appear to lead to lower bond spreads and higher credit ratings because of the lower credit risk perceived for socially responsible issuers.

How Is This Research Useful to Practitioners?

According to the US Social Investment Forum, the socially responsible investing (SRI) fund industry grew from $12 billion in assets under management in 55 funds in 1995 to $316.1 billion in assets under management in 250 funds in 2010—a substantial increase in assets over time.

Because of the evident interest within the industry in firms exhibiting a socially responsible business mentality, researchers have already been investigating the links between CSP and corporate financial performance. Most of the pertinent research has focused on the equity markets and concluded that weak social responsibility from corporations is usually associated with higher stock return volatility.

In this context, the authors examine the extent to which the differentiation of credit quality, in terms of bond spread and credit rating, may also be partly explained by different levels of CSP strengths and concerns (i.e., weaknesses). They find that firms with socially responsible strengths are rewarded with lower credit spreads and higher credit ratings, whereas firms with CSP concerns are penalized with higher spreads and lower ratings. Moreover, it is found that support for local communities, higher levels of marketed product safety and quality, and avoidance of controversies regarding the firm’s workforce can materially reduce the spread of corporate bonds.

The authors’ findings may encourage social responsibility among both corporate and asset managers. Firm managers should be aware that showcasing a socially sensitive business plan can help draw funds from the fixed-income markets at a lower cost. Institutional investors in fixed-income markets, however, should not refrain from incorporating CSP strengths and concerns when assessing the riskiness of potential investments. By specifically choosing socially responsible corporations to lend to during credit crunch times—when uncertainty is high—asset managers benefit from lower default risk and become part of the SRI community.

How Did the Authors Conduct This Research?

The authors perform multivariate regression analysis, whereby either the credit rating of the bond issue or the logarithm of the bond spread is alternatively regressed against a CSP measure. The CSP regressor takes the form of the aggregate of either CSP strengths or CSP concerns in two separately estimated regressions. KLD Research and Analytics data are used to rate firms on issues surrounding community relations, diversity, employee relations, the environment, and product safety and quality. Numerous explanatory variables are added to the equation to control for the market capitalization, leverage, return on assets, and industry of the issuer, as well as for the maturity, duration, convexity, and nominal amount of the issue.

The sample consists of data for 3,240 bonds free of embedded options or nonstandard characteristics issued by 742 nonfinancial and nonbanking firms, corresponding to 7,794 bond-year observations during the period of 1993–2008. Bond ratings from Standard & Poor’s are used, and firm characteristic data are sourced from Thomson Reuters DataStream. The estimation is performed on the basis of pooled ordinary least-squares regressions with two-way (cross-firm and cross-year) clustered standard errors. Several robustness specifications that follow the main analysis control for industry-specific factors, multicollinearity, and multiple issues from the same firm.

Because the costs/benefits of CSP are experienced in the long run, bonds with longer maturities are more affected by these social issues. Given the tenuous nature of the lowest-rated bonds, managers of speculative-grade firms can significantly improve their bond spreads and default risk by improving their social responsibility or resolving CSP issues, especially those related to employee relations and product and environmental liability.

Abstractor’s Viewpoint

In sum, the authors empirically confirm that corporate social responsibility is linked with the credit quality and default risk of a company. Namely, bonds issued by firms that care for all stakeholders rather than just stockholders confer benefits in the form of higher credit ratings and lower default spreads, all else being equal. Yet, what remains to be investigated is whether the foreseen negative relationship between positive CSP and credit risk is the result of inherent endogeneity among such fundamental factors as profitability or leverage and the CSP measures.

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