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Journal of Business Ethics (2010) 96:117134 Springer 2010

DOI 10.1007/s10551-010-0452-y

Corporate Social Responsibility:

Is it Rewarded by the Corporate
Bond Market? A Critical Note Klaus-Michael Menz

ABSTRACT. The question of whether corporate social developing holistic aims and objectives. In this
responsibility (CSR) has a positive impact on firm value context one often speaks of focusing on the so-called
has been almost exclusively analysed from the perspective triple bottom line, i.e. the contemporary consid-
of the stock market. We have therefore investigated the eration of economic, social and environmental
relationship between the valuation of Euro corporate aspects in the formulation of corporate guidelines. For
bonds and the standards of CSR of mainly European
others, the growing corporate attention to social and
companies for the first time in this article. Generally, the
debt market exhibits a considerable weight for corporate
environmental factors simply is an inevitable conse-
finance, for which reason creditors should basically play a quence of many years of excessive focus on short-term
significant role in the transmission of CSR into the val- profit maximization (Korner, 2005). Another reason
uation of financial instruments. Given that socially for the increased interest in sustainability issues is the
responsible firms are often regarded as economically more assumption of many investors that a high standard of
successful and less risky, they should have lower risk CSR should be reflected in a superior long-term
premia. The results of the empirical analysis, however, development of the company value.
reveal that based on an extensive data panel the risk In the meantime numerous studies have been
premium for socially responsible firms according to the published which approach the relationship between
classification by SAM Group was ceterius paribus higher CSR and business success from different angles. The
than for non-socially responsible companies. However, focus was often the question of whether a socially
only one case of the models investigated was weakly
responsible management approach leads to an
significant. Thus, largely the relationship has to be clas-
sified as marginal; so CSR has apparently not yet been
increase in corporate operating income, and in par-
incorporated into the pricing of corporate bonds. ticular to higher stock prices (Griffin and Mahon,
1997; Margolis and Walsh, 2003; Orlitzky et al.,
KEY WORDS: corporate social responsibility, corpo- 2003). But also the influence of CSR on a number of
rate citizenship, sustainability, triple bottom line, social company-specific risk ratios (for example, earnings
performance, credit spreads, corporate bond evaluation volatility, leverage or stock beta) has been analysed as
the meta-study by Orlitzky and Benjamin (2001)
demonstrates. Recent studies have also examined
whether a link exists between CSR and cost of capital
Introduction (Bassen et al., 2006; Di Giulio et al., 2007). How-
ever, the influence of CSR on the valuation of credit
The interest in corporate social responsibility (CSR) instruments has not to our knowledge been
has increased almost explosively in recent years. One researched in any study as yet. This article aims to fill
reason for this development is possibly the fact that this gap.
even profit-oriented companies, faced with global The debt market is highly important for the
climate changes, scarce resources and growing social external financing of corporations (ECB, 2007).
tensions resulting from increased wealth disparity, Therefore, in principle, creditors have the potential
are increasingly realizing the social necessity of to provide for a transmission of CSR in the valuation
118 Klaus-Michael Menz

of credit instruments through their business activi- pursuant to Renneboog et al. (2008) the sum of
ties. The question which arises is whether this ecological efficiency, good corporate governance
potential is actually put into practice. As socially and good relations with the various stakeholders of
responsible companies are generally considered to be the company.
less risky (Soppe, 2004), the lenders have an incen- In the Anglo-Saxon language area, the expressions
tive, however, to incorporate CSR in their assess- CSR, corporate citizenship, sustainability, triple
ment. Consequently, a high degree of managerial bottom line and social performance are often used
responsibility, ceteris paribus, should be reflected in synonymously (Mercer, 2007). Since, however, no
a lower risk premium. As the availability of data on single definition of CSR exists, neither in existing
individual terms of bank loans (maturity, cost, etc.) is literature nor in language use, divergent interpreta-
quite limited, we will assess the relationship between tions of the terms are common (Bassen et al., 2006).
CSR and debt risk premiums using the example of The linguistic and partly conceptual diversity of the
the thriving market for Euro corporate bonds CSR idea has led to increased confusion amongst the
(Deutsche Bundesbank, 2004). general public (Margolis and Walsh, 2003), which is
The remaining article is structured as follows. probably not conducive to the dissemination of the
Following a definition of the concept of CSR we concept and recognition of its far-reaching impor-
first discuss in section Aspects of the corporate tance in society.
social responsibility theme: a general overview why According to the traditional principle of ratio-
companies should theoretically in addition to nality, companies and their top managers should
economic factors also incorporate social and only pursue one objective under the shareholder
environmental factors and how CSR should affect value primacy, namely that of profit maximization
the corporate success in practical terms. In section (Jensen, 2001; Rappaport, 1986). A consideration of
Corporate social responsibility and credit spreads: social or environmental issues would only produce
transmission and hypotheses, the transmission unnecessary costs which would conflict with the
mechanism between CSR and credit markets and target of an increase in share price. Moreover, a
possible evaluation relationships between corporate multidimensional objective function, which aims to
bonds and socially responsible business policy are maximise not only the economic but also the social
discussed. Given that CSR is a very complex issue value of the company, would hamper the efficient
that is difficult to measure, we deal with this aspect design of management contracts and thus signifi-
in more detail in section Measurement of corporate cantly reduce the performance incentives of the
social responsibility. In section Empirical analysis companys management given the difficult perfor-
the empirical analysis is conducted. First, the data- mance measurement (Tirole, 2001).
base used and the control variables are presented, Nevertheless, non-traditional behavioural models
then methodological aspects are discussed and finally are moving away from this neo-classical perspective,
the results are interpreted. This article concludes including the assumption of a one-sided human
with a summary and issues for future research in utility structure with the model of a strictly selfish,
section Conclusions and implications. profit-oriented homo oeconomicus and now also
take into account social, emotional and ethical
aspects as beneficial factors in the target system of a
Aspects of the CSR theme: a general company (Cornell and Shapiro, 1987). Various
overview articles (Fehr and Gachter, 2000, 2002; Guth et al.,
1982; Trivers, 1971, 1985; White, 2004), for
Corporate social responsibility is defined as a example, have shown that social and ethical values
corporate policy that includes social, ethical and also affect economic behaviour (fairness, reciprocity)
ecological aspects. According to the European and that subjective utility often also depends on the
Commission (2002), it is a concept by which com- utility of others and all, respectively (altruism).
panies voluntarily integrate social and environmental Moreover, the violation of social norms, for example
issues in their business activities and in their inter- the discrimination of minorities in the workforce or
actions with various stakeholder groups. CSR is severe air pollution, can cause a significant loss in
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 119

reputation for the company and its managers alternative must be identified through compensatory
(Akerlof, 1980), which can, irrespective of any evaluation of all options (optimization) alone.
financial costs (litigation, fines), negatively affect The practical mechanism leading to better eco-
even basic human emotions such as pride and self- nomic development of socially responsible compa-
esteem (Elster, 1998). From the perspective of Fama nies in comparison to other firms is as complex as
and Jensen (1983), public reputation even represents intuitively obvious. Amongst other things, CSR
the main motivating factor for managers. Further- might attract qualified employees, who are moti-
more, the aversion against having to regret (at least vated and remain with the company for longer
in part) a decision (regret aversion) can cause an periods (Phillips et al., 2007, p. 6). In this context,
undesirable state of cognitive dissonance that man- the above-mentioned fairness aspect plays a very
agers as well as most economic agents usually want important role. As contractual arrangements for
to avoid (Festinger, 1957, Kahneman and Tversky, employment contracts are typically incomplete,
1982). This increased mental stress for the manage- because the wages are usually fixed, but the job
ment, in particular, stems from the negative conse- performance is determined within certain limits
quences of a deliberately chosen alternative. For through the commitment and the input of individual
example, the investment in an older production workers, working morale has great relevance for the
technology is often initially cheaper, but it generates success of the company. Good working morale, in
increased environmental pollution and may thus lead turn, is exhibited by employees if they feel that they
to public protests at a later date. In addition, other are fairly treated and remunerated (Fehr and Falk,
stakeholders of the company (including shareholders, 1999). Moreover, socially responsible enterprises
customers, employees, suppliers, government, etc.) have lower costs due to less production-related
could exert additional pressure on the management environmental damage and possible litigation, which
and thus reinforce the state of dissonance. in turn improves the reputation and enhances the
Amongst the intellectual roots of a sustainable, brand value. Furthermore, such companies often
socially responsible corporate policy, the behavioural maintain good relations with public institutions and
theory of the firm by Cyert and March (1963) is of other organizations, therefore creating a positive
significance, which advocates a more realistic char- moral capital with insurance-like effects that has a
acterization of this form of organization. According positive impact on the value of the company
to Winter (1964), the work of Cyert and March (Godfrey, 2005). Overall, long-term competitive
(1963) represents a scientific revolution, which advantages could be achieved, also because cus-
expressly questions the mean whilst dominant theory tomers are often more loyal and thus higher earnings
of the profit-maximizing company. This alternative and/or margins are attainable.
firm theory includes as the main constituent ele- However, the consideration of social and envi-
ments, amongst others, the assumptions that com- ronmental factors is also directly associated with
panies consist of political coalitions of individuals higher costs, because, for example, extensive health
and groups with time-varying and sometimes and safety measures or modern, environmentally
conflicting needs resulting in multidimensional friendly production facilities are expensive. This
objectives of the firm that the economic agents could result in a decrease in profitability and com-
involved are boundly rational in the sense of Simon petitiveness of a company. As the side effects caused
(1957), and that the decision-making process espe- by entrepreneurial activity (for example, air and
cially consists of finding satisfactory, instead of water pollution, health impairments), are often not
optimal solutions for problems (satisfying principle; or not fully borne by the polluter (imperfect inter-
Simon, 1955). The behavioural theory of the firm nalisation of external effects), less responsible com-
stands in marked contrast to the neoclassical panies could benefit economically at the expense of
approach, which presumes profit maximization, sets society. Therefore, sceptics assume that socially
unrealistic assumptions, and which describes the responsible companies may have a poorer perfor-
organization as a given bundle of options for action, mance than firms that only concentrate on short-
in which the alternatives and their associated con- term economic success (Preston and OBannon,
sequences are well known, meaning that the best 1997; Shleifer, 2004). This assumption is supported
120 Klaus-Michael Menz

by results of interviews with various stakeholders of shares) (Heinkel et al., 2001) and secondly share-
companies, whereby, for example, many share- holder activism (Smith, 1996). By investing in
holders and customers are hardly interested in the companies with high CSR standards and/or an
topic of CSR (Steger et al., 2007). Moreover, avoidance of sin stocks (Hong and Kacperczyk,
studies show that many people reveal a very 2005), investors can indirectly influence the behav-
ambivalent attitude towards public goods. According iour of companies. By focusing on socially respon-
to Kahneman et al. (1998), individuals often show sible companies, their stock prices should ceteris
generally positive attitudes in experiments, for paribus increase faster than those of other companies.
example, towards the preservation of rare species or This increases the (relative) cost of equity for the less
the preservation of intact ecosystems, but it is not a responsible companies, thus the company could be
matter of economic preferences, because most peo- pushed to adhere to higher CSR standards. Since
ple only maintained their positive attitude as long as according to Eurosif (2006) socially responsible
the conservation of such public goods costs little or investments represent only about 1015% of all
nothing. Moreover, many consumers seem to show European fund investments (public and special
no willingness to pay more for products from socially funds), the interference potential is, however, only
responsible businesses than for comparable normal moderate from a quantitative perspective. Moreover,
products. Against this background, it seems quite according to the pecking order theory, the majority
questionable whether socially and environmentally of companies only relatively seldom use the stock
oriented companies can in fact achieve higher eco- market as an external source of financing (Myers and
nomic success because of their reputation and loyal Majluf, 1984); so potential pressure due to increased
customers. capital costs will only sporadically be effective. If
In summary, according to the above discussion it companies raise additional equity capital, then this
is debatable whether the corporate objective func- step as has been empirically proven is taken
tion includes social, ethical and environmental almost exclusively after a very positive stock price
factors in addition to economic factors and whether development, in other words when the risk appetite
high CSR standards are reflected in economic amongst investors is high and the capital costs are
success. Ultimately, these and similar questions can low (Baker and Wurgler, 2002). Especially in the
be answered only empirically. final stages of bull markets, investors often behave
irrationally, because they neglect fundamental factors
whilst evaluating, demand too low risk premia and
Corporate social responsibility and credit all too often follow the herd instinct (Shiller, 2000).
spreads: transmission and hypotheses The possibilities of exerting pressure on companies
via higher (equity) capital costs therefore have to be
Following the preceding background discussion, the considered to be limited.
next step will draw up concrete hypotheses about As socially responsible (equity) investment per se
the relationship between CSR and credit spreads. In can be judged as being ineffective for the reasons
order to show the special importance of bond described above, shareholder activism is regarded as
investors as market disciplining forces, who can being a more appropriate transfer mechanism
influence the CSR of companies by their actions, we (Johnsen, 2003). Through active participation in
will first discuss the possibilities and limitations of general meetings investors can generate a broader
these and other transmission mechanisms by the public awareness of CSR issues and possibly achieve
capital market. (through persuasion) changes in business practices.
By coordinating with other stakeholders and bun-
dling and exercising voting rights, a significant
The transmission of corporate social responsibility influence on the management could be exercised
by the capital market (Grundfest, 1993). However, the existent results on
the success of an active shareholder strategy with a
Amongst the traditional transmission channels for few exceptions (Monks and Minnow, 1995; Smith,
CSR are first socially responsible investments (in 1996) also tend to be sobering (Haigh and
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 121

Hazelton, 2004). In this context Heinkel et al. actions are executed bilaterally amongst institution-
(2001) confirmed that a much higher number of als via the phone (Schultz, 2001), direct
socially responsible stock investors is needed to participation of private investors in this market can
exercise substantial influence over the management. also be largely excluded. The very small direct
This means that at least 25% of such investors are influence of private investors in the debt market has
necessary, but according to the data from Eurosif two implications. First, private investors trade on
(2006) the actual number is currently far lower. the basis of less and lower quality of information
In contrast, the potential impact of the credit and often act more irrationally than institutional
market on a company is much higher. First, the investors (Barber and Odean, 2000; Locke and
balance-sheet debt of European companies is gen- Mann, 2005), which is why they are probably much
erally much higher than the equity (ECB, 2007). less able to take a very complex issue such as CSR
Lenders therefore have the quantitative potential into account efficiently in investment decisions.
and as discussed below also the incentive to Thus, the low market participation of private
convince companies to exercise responsible behav- investors increases the probability that CSR is
iour (Scholtens, 2006). For example, leading banks incorporated as an influence factor in the valuation
nowadays view environmental and social issues as of financial instruments. On the other hand, we
real risk variables that may affect their creditors as know from the stock market that here individuals
well as their own performance. This has led to the play a greater role as direct investors and therefore
creation and adoption of the Equator Principles, the owners rights are often more widely dispersed.
which aim to incorporate environmental and social This tends to increase the freedom for the man-
standards into project lending practices of banks agement (to ignore external demands), because a
(Esty et al., 2005).1 In addition, banks like HSBC high free float reduces the incentive to control and
(2009) also see business opportunities in environ- discipline the corporate management (Shleifer and
mental or social issues (i.e. acting as an adviser for Vishny, 1986). Since institutional investors have a
customers capital spend or banks own investments high significance in credit markets because of their
in innovative projects). Secondly, companies need to size and concentration, the influence by the lenders
revert to the debt market for external finance more should generate more pressure potential.
often, because both the maturity of bank loans and
bonds in general limited. If a company does not fulfil
the CSR requirements, then it risks being exposed The influence of corporate social responsibility
to market discipline. The lenders could namely on credit spreads
refuse to extend expiring loans and/or to buy new
bonds of the issuer. In order to not jeopardize The credit spread of a corporate bond or another
regular refinancing, the managers are forced to meet debt instrument represents a compensation for the
the needs of creditors adequately. Thirdly, even risks which the investor additionally incurs in
non-public companies (partnerships, companies comparison to risk-free investments (e.g. Treasury
without a public stock listing) take on debt. For this bonds). Credit risk, liquidity risk and systematic risk
reason, the potentially disciplining effect of the number empirically amongst the main components
credit market reaches far more companies than the of this risk premium (Nelles and Menz, 2007).
stock market. Fourthly, the Euro credit market is However, almost all investigations of credit instru-
dominated by institutional players. Whilst banks ments reveal that these evaluation factors are not
especially do the traditional lending business and act fully able to explain the level of actual credit spreads
as intermediary between supply and demand of (Amato and Remolona, 2003). Thus, there must be
capital by size and maturity transformation, invest- more risks, which are priced by the market partici-
ment companies, insurance firms and pension funds pants.
play an essential role as buyers in the market for Empirical results of Bollen et al. (2005) identify
corporate bonds. As the corporate bond market is fraud or unethical behaviour by the management as a
characterized by decentralized OTC dealing (over dominant factor of influence for the collapse of large
the counter market), where the majority of trans- European firms, which is predominantly due to
122 Klaus-Michael Menz

ineffective corporate governance mechanisms. In reputation loss, expenses for the elimination of
addition, the largest and most prominent case of environmental pollution, etc.) that lower the com-
insolvency in the Euro corporate bond market, the panys profits, is possibly due to an increase in
Italian dairy company Parmalat SpA, was ultimately company-specific risk premium. Derwall et al.
caused by bad corporate governance, which made (2005) also discover that eco-efficient companies
fraudulent mismanagement, accounting irregularities have better stock returns than firms that consume
and deficient firm control possible (Buchanan and more resources and/or produce more waste in their
Yang, 2005). Therefore, one of these missing risk business activities. However, environmental issues
factors should be corporate governance. Indeed, are also important for bondholders and creditors. For
Nelles and Menz (2008) show that, in addition to instance, heavy litigation claims due to asbestos
the above-named factors, the corporate governance contamination led to a massive deterioration of the
quality has an influence on the risk premium of issuer credit rating of the SwissSwedish engineering
credit instruments of European companies, although firm ABB from investment grade (AA-/Aa3) to
the evidence, however, is very weak. As corporate junk (B+/B1). Furthermore, there are banks that
governance is only a part of CSR, one can assume became legally responsible to pay for the clean-up on
that for other aspects of socially responsible firm foreclosed property which had been contaminated
behaviour a greater impact may be proven. In by borrowers (e.g. in the 1980s and 1990s US-based
addition to environmental policy, this applies espe- Maryland Bank & Trust and Fleet Financial).
cially to relations with the various stakeholders of a Accordingly, wasteful companies should possess a
company, which mainly means that the respective higher risk premium than firms with high eco-
interests of the stakeholders are adequately consid- efficiency or low environmental issues.
ered and protected. Overall, socially responsible firms can be regarded
The lenders belong to the important primary as less volatile and risky (Di Giulio et al., 2007;
stakeholders of a company just as shareholders or Orlitzky and Benjamin, 2001; Spicer, 1978). As
employees do. As the ability of a company to create these companies are less heavily burdened by the
sustained added value is determined mainly through negative financial consequences of their business
(good) relations with its essential stakeholders (see activities (for example legal costs, damages, fines,
Post et al., 2002, p. 9), good companies with their conditions), their operating results often prove to be
long-term orientation will promote fair and open more stable which is usually reflected in a less vol-
interaction with its lenders that will be rewarded by atile stock price. Systematically lower operational
them presumably with lower yield requirements. In and financial risks should, ceteris paribus, lead to
particular, the bondholders of a company are affected lower yield claims by the lenders and hence lower
by specific principal-agent conflicts because manag- risk premiums. Theoretically, this conclusion is also
ers generally have an incentive to behave opportu- substantiable with the help of Mertons structural
nistically to the benefit of shareholders who, credit risk model (1974), because in this approach a
ultimately, are paying them. Under certain condi- reduced volatility of the firm value also leads to a
tions, the equity providers benefit from the execu- lower risk premium.
tion of very risky investment projects, because they On the basis of these considerations, we derive
harvest most of the gains if the project is successfully the hypothesis that companies with a socially
completed, whilst a failure would even be to the responsible corporate policy should have, ceteris
detriment of the creditors. Generally speaking, it is paribus, lower credit spreads than those that are
about a possible wealth transfer from bondholders to following less holistic guidelines.
shareholders (Alexander et al., 2000).
Moreover, empirical studies show that environ-
mental factors significantly affect the valuation of Measurement of corporate social
companies. For example, Klassen and McLaughlin responsibility
(1996) reveal a decline in the share price after
environmental disasters, which in addition to Many studies on the relationship between social and
the direct and indirect-cost items (customers and financial development of firms face the problem of
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 123

how this can be measured (Margolis and Walsh, has also determined the relevant investment universe
2001; Scholtens, 2008). Due to complex interrela- for the first global sustainability stock index, the
tions and numerous elements of a good and Dow Jones Sustainability Index (DJSI World).
holistic corporate policy, CSR is not easy to assess. SAM Researchs selection of the company is based
Furthermore, CSR screens are inherently subjective. on the best in class approach. Here the leading stock
In addition, the collection of relevant data is asso- companies in every industry are identified on the
ciated with very high efforts. Therefore, from a grounds of numerous economic, environmental and
practical point of view the use of specialized external social criteria, assessing issues such as corporate gov-
services is required in order to evaluate the CSR. ernance, risk management, climate change mitiga-
One of the worlds first rating agencies, special- tion, supply chain standards and labour practices and
izing on the analysis and assessment of corporate taking sectoral specifics into account when selecting
social performance, is Kinder, Lydenberg and for the investment universe. The three groups of
Domini (see Sharfman, 1996). The selection pro- criteria each account for 33% in the valuation. The
cedure of Kinder, Lydenberg and Domini (KLD) overall verdict is essentially made up to equal pro-
takes the multidimensionality of CSR into account, portions of general and industry-specific factors,
including factors such as social engagement, corpo- which in total include approximately 130 individual
rate governance, diversity, employee relations, criteria. However, as not all sectors are affected by the
environment, human rights and product character- same level of economic (e.g. corruption), environ-
istics on the valuation list. As part of the evaluation mental (e.g. eco-efficiency) and social (e.g. employ-
positive and negative factors are listed separately for ment conditions) problems; this is adequately
each individual topic, so that the strengths and considered when conducting the industry analysis.
weaknesses of a company with respect to CSR The sustainability assessment is carried out based on
become more recognizable. A disadvantage of the a comprehensive questionnaire, which is completed
extensive KLD database is, however, that it primarily by the company that is to be evaluated. In order to
contains information about U.S. corporations. verify the obtained data SAM uses direct corporate
Moreover, the calculation methodology has been information that the analysts get via personal inter-
criticized because almost all factors have the same views and company visits in addition to public sources
weight (see Di Giulio et al., 2007, p. 9). This (annual reports, company websites, and image bro-
complicates the intersectoral comparability, as the chures). All data are stored in a database and regularly
different themes do not have the same importance reviewed by an accounting firm. In most cases, SAM
across all industries (see Steger et al., 2007). Obvi- reviews a CSR evaluation once a year.
ously, in a sector comparison social, societal and From various studies it is known that the quan-
environmental aspects are of differing relevance. For tification of CSR is very difficult. For this reason the
example, in the energy and chemical industry measurement of the relationship between CSR and
environmental issues play a more important role, various financial variables (security price develop-
whereas in the textile and toy industry (e.g. child ment, price volatility, risk premiums) can be signif-
labour) as well as in food and beverage manufac- icantly affected (McWilliams and Siegel, 2000). For
turing (e.g. fair remuneration of farmers in devel- this reason, SAM undertakes complex evaluation
oping countries) social factors often come first. procedures by which, with the assistance of external
Due to the limitations of the KLD rating, the so- experts (universities), the meaningfulness of the
called Corporate Sustainability Assessment of Sus- evaluation results should be ensured.
tainable Asset Management Research (SAM) is used The results of the SAM sustainability analysis are
in this study to measure the firm-specific quality of documented in various rankings. In this study we
CSR (see for further detailed revert to the Investment List, which includes the
information about the research process). The SAM basic investment universe of SAM with about 500
Group is a financial research company based in worldwide leading sustainable companies. However,
Zurich, which has focused on socially responsible this list does not allow further differentiation
investments and the evaluation of CSR since 1995. between the listed firms, because there are no scores
Since its introduction in 1999, the SAM Research or rank numbers indicated. Therefore, it can only be
124 Klaus-Michael Menz

judged in a binary manner, which means that a for alternative influences on the credit spread.
company is either socially responsible (it is on the McGuire et al. (1988) argue, for example, that so-
list) or non-socially responsible (it is not on the list). cially responsible companies are generally charac-
terized by a low debt level which affects the risk
profile significantly. In this context Ederington and
Empirical analysis Yawitz (1987) demonstrated that especially hard
financial ratios for financial and business risk of a
In the next step of the investigation, we will firm (for example, debt ratios, interest coverage
examine the hypothesis developed in section ratio, profitability) along with soft criteria such as
Corporate social responsibility and credit spreads: management quality are key determinants of credit
transmission and hypotheses that companies with a ratings. Credit ratings of the prestigious agencies
socially responsible corporate policy, should, ceteris Standard & Poors, Moodys and Fitch are in turn
paribus, have lower credit spreads than those that the traditionally predominant indicators of credit risk
pursue less holistic guidelines. (Crouhy et al., 2001). Even more, credit agencies
provide a public certification effect that makes
investors reluctant to lend if an issuer has no rating at
Data and control variables all (Sufi, 2009). Consequently, when estimating the
empirical relationship the creditworthiness of the
Our data panel consists of 498 bonds with observed company has to be explicitly taken into account, in
values over 38 months. After the elimination of order to make sure that the CSR indicator ultimately
outliers and the deduction of missing values, a total measures not only the credit risk.
of 16,957 observations remain for the analysis. The Empirical studies also show that the various
sample used includes all fixed-income securities in industry sectors at the corporate bond market have
the Merrill Lynch Non-Financial Corporate Bond different risk premiums despite identical ratings
Index (ticker symbol: EN00) that are constituents at (Longstaff and Schwartz, 1995; Nelles and Menz,
the end of May 2006.2 All investment grade bonds 2007). As the respective industrial sectors have dif-
(BBB-/Baa3 or better) with remaining maturities of ferent structural characteristics and cyclical sensitiv-
1 year and longer and an issuance volume of EUR ities, the systematic risks of the sectors vary as do the
100 million and more are enclosed in this index, corresponding risk premiums. A consideration of
whereas the sample actually only contains bonds sector effects is also advisable in view of findings of
with a nominal value of more than 250 million the CSR Research that the social, societal and
Euros (sample median: 600 million par value). With environmental issues in different sectors are of dif-
the exception of some hybrid issues, the majority of fering relevance (Scholtens, 2008; Steger et al.,
securities are senior bonds with no extra features, 2007). Thus, sector effects are controlled for by the
such as call options or interest deferral clauses. This inclusion of industry dummies.
universe was observed between the end of July 2004 Bonds are also subject to the systematic interest
and the end of August 2007 over a historical period rate risk, because their prices may vary depending on
of 38 months. All monthly bond data used in the movements of market yields (Fama and French,
analysis (features, credit spreads, modified duration, 1993). In accordance with the liquidity preference
credit rating, sector membership) are taken from the theory (Hicks, 1939) investors require an additional
Merrill Lynch index system. premium for this monotonically with the maturity of
When econometrically measuring the relationship the bond increasing risk. In principle, this applies
between CSR and financial development specifica- both to the yield curves of (credit) risk-free gov-
tion problems often arise because CSR indicators ernment bonds (Drakos, 2001) as well as risky bonds.
frequently correlate with other firm ratios and thus For corporate bonds with an investment grade
the influence of CSR on the performance is often rating, Fons (1994) and Kao (2000) amongst others
artificially distorted upwards (McWilliams and show that the risk premium as measured by the
Siegel, 2000). Besides the selection of an appropriate credit spread is a positive function of the bond
CSR indicator, it is therefore necessary to control maturity. In order to reduce the distorting influence
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 125

of different maturities on the valuation, the modified heteroscedasticity (generalized least squares (GLS)-
duration is used in the analysis as a control variable specification).
for the interest rate risk. Basically, the higher the As summarized in Table I, we have set up eight
modified duration is, the more sensitively the bond different models in order to investigate whether
prices react to variations in interest rates (Fong and there is a significant correlation between credit
Fabozzi, 1985). spreads (dependent variable) and CSR (CSR)
Finally, the influence of company size as a factor has taking control variables into account. In the first
to be considered because it is likely that larger firms variant, only the indicator variable for CSR is in-
have more resources to invest in CSR and are able to cluded as an explanatory factor in the standard
afford CSR, respectively (Di Giulio et al., 2007). As regression model (pooled OLS). The regressor is
this aspect, however, is already reflected in credit rat- significant at the 1% level and has the assumed
ings, because larger companies tend to receive better negative sign. However, the very low R-squared
credit ratings, the inclusion of an additional indicator (1.70%) signals little explanatory power of the model.
for the size of the company is not mandatory. Also, the F-test clearly indicates that the fixed effects
approach is preferable to the simple pooled OLS
method (model 2). Intuitively, this result is also
Methodology and results understandable as the universe is composed of dif-
ferent bonds (credit rating, maturity) of different
After considering the application requirements three issuers (industries). Therefore, given this cross-
different panel econometric methods are in principle sectional heterogeneity issue-specific effects play a
available for the empirical analysis (pooled ordinary considerable role for the evaluation, which is allowed
least squares (OLS), fixed effects and random effects for in the fixed effects model. In this model specifi-
model, see Baltagi, 2001, for details). With the aid of cation, the CSR indicator loses any significance and
these and taking the control variables into consid- the negative sign. Based on the Hausman test, which
eration, we can examine whether a significant cor- in addition is used to determine the suitability of the
relation exists between credit spreads and CSR fixed effects model in comparison to the random
quality, both in cross section as well as over a period effects approach, one concludes that the fixed effects
of time. The question which of the three models is approach is preferable from a methodical view, due to
most appropriate for the analysis is answered by the the significant test statistics. In the models 3 and 4, we
model specification tests in Table I. extend each estimation equation with the two control
The significance of the F-test shows the superi- variables modified duration (MD) and rating
ority of the fixed effects model in comparison to the (RAT) in order to take into account the hetero-
simple pooled regression. Accordingly, individual geneity caused by different interest rate sensitivity and
effects play a role which is relevant to evaluation, credit quality. In both cases, except for the CSR all
and the assumption of homogeneity of all cross- other regressors variables are significant (1% level),
section objects over time, which is reflected in a with the model specification test demonstrating again
common intercept in the pooled OLS, can be the superiority of the fixed effects approach in com-
rejected. The Durbin-Watson test statistics (not parison to the simple pooled regression procedure.
reported) indicate positive autocorrelation in the The null hypothesis of the Hausman test is rejected
residuals. Therefore, robust covariance estimations at the 1% level of significance; so also in this case
of the coefficients based on the period method of the fixed effects model is most appropriate. The
White are conducted, which are insensitive to R-squared of the regression increases with this version
autocorrelation and time-variable variances in the to almost 77%.
residuals (Arellano, 1987; Beck and Katz, 1995). In To further support the robustness of our results, we
addition, as it can not be assumed that the residual add a total of 13 dummies for industry affiliation in
variances will be constant across all cross-section model 5 (TELEC = telecom, UTILI = utility,
objects, but rather should vary in a company-specific CC = cyclical consumption, CNC = non-
way, a cross-section weighting is used when esti- cyclical consumption, BASIC = basic resources,
mating the panel, which enables a correction of this SC = cyclical services, CG = capital goods,
Results of the panel models 126

Model 1 2 3 4 5 6 7 8
Variant 1 1 2 2 3 3 4 4

Independent variables
C 52.16547*** 54.58435*** 2.715949*** 52.43934*** 0.38181 -1.796888*** 24.87637***
(0.747) (0.458) (0.874) (1.628) (1.029) (0.640) (1.016)
CSR? -4.858389*** 0.636304 0.750547 0.459569 0.151475 0.160348 0.210792 0.907209*
(0.972) (0.960) (0.588) (0.981) (0.623) (0.612) (0.408) (0.540)
MD? 4.811213*** -1.351075*** 4.797912*** 4.799468*** 5.617893*** 4.339101***
(0.149) (0.231) (0.142) (0.142) (0.116) (0.160)
RAT? 0.119683*** 0.040916*** 0.105407*** 0.105361*** 0.113954*** 0.027839***
(0.003) (0.005) (0.003) (0.003) (0.002) (0.003)
TELEC? 11.62227*** 11.23178***
(1.371) (1.152)
UTILI? 0.389821
CC? 4.186633*** 3.807883***
(1.165) (1.016)
CNC? 6.707996*** 6.325554***
(0.990) (0.965)
Klaus-Michael Menz

BASIC? 4.746550*** 4.360812***

(1.185) (0.968)
SC? 4.836383*** 4.465165***
(1.261) (1.108)
CG? 6.860420*** 6.468650***
(1.413) (1.271)
ENERG? 7.899035*** 7.525113***
(1.788) (1.838)
REAL? 10.71789*** 10.33708***
(2.290) (2.173)
MEDIA? 10.16247*** 9.790900***
(2.110) (1.991)
TECHN? 1.607
SNC? 12.99140*** 12.61436***
(1.210) (0.963)
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 127


Panel regressions of 498 bonds over the period between July 2004 and August (May) 2007. Robust standard errors and covariance matrix based on the period method of White.
ENERG = energy, REAL = real estate,


MEDIA = media, TECHN = technology,

SNC = non-cyclical services) and the potential

bond subordination (SUB). Thus, industry-

specific effects will be incorporated in the evaluation.


Except for two industry dummies (utilities and

technology) and the CSR indicator, all other

regressors are significant. In model 6, the two insig-

nificant dummies were removed from the estimation


equation, but that has almost no effect on the


remaining regressors. In particular, the coefficient of

CSR is still not significant and has a positive sign. The
R-squared of this variant lies at just under 57%, well


below the level of model 4, which indicates for



evaluation that firm-specific heterogeneity as


measured by the fixed effects approach is more


relevant than industry-specific distinctions. The fact

that company heterogeneity is also dominant in case

***, ** and * indicates significance on the 1%-, 5%- and 10%-level. Robust standard errors in brackets.

of sector identity had already been identified by Cyert

and March (1963) as a fundamental issue.


In our last two models 7 and 8, we estimate the


models 3 and 4 on the basis of a period which was


shortened by 3 months, so lasted only until the end


of May 2007. This approach takes into account that




the financial crisis broke out openly in summer


2007, which resulted in significant market distor-


tions that might have exerted a distorting influence


on our results. This suspicion was also nourished by

a striking finding in model 4, namely the negative
parameter value for the variable interest rate risk

(MD). As the results in Table I show, for the



shortened period with the fixed effects method


estimated MD coefficient value changed its sign as


expected (model 8). In contrast, the coefficient of

the CSR indicator also remains positive in this


specification with the t-statistic in this case indicating


even a weak significance at the 10% level (p-value


0.093). The goodness of the regression is above


average as measured by a R2 of over 88%. In the


pooled OLS model (model 7), which is inferior to

the alternative fixed-effects specification according

to the F-test, the estimated CSR coefficient retains

F-test (OLS versus FE)


the insignificant positive sign compared to model 3.

Model specification tests

(FE versus RE)




In summary, contrary to our hypothesis, bonds of


socially responsible corporates do not have lower

128 Klaus-Michael Menz

risk premiums than those of non-socially responsible creation of shareholder value as a screening target.
companies. The investigated models mostly identi- However, the empirical evidence shows that the
fied positive coefficient values for the CSR factor; so simultaneous realization of shareholder value and
in fact the direct opposite seems to be the case. bondholder value is often difficult because of agency
However, the estimated positive relationship problems (Menz and Nelles, 2006). For example,
between credit spreads and CSR is only (weakly) extensive shareholder rights and a lack of protection
significant in one model. There are several possible against takeovers are generally regarded as being
explanations for this apparent lack of relevance of positive for shareholder value, whilst the bondholder
CSR for the corporate bond evaluation. value tends to be affected negatively by that. Essen-
One main reason is that obviously credit ratings tially, the more anti-takeover mechanisms, the better
matter more for bond investors than CSR ratings, as for holders of investment grade bonds because of
indicated by the highly significant and positive lower event risk (Bradley et al., 2007). In fact, this
RAT coefficients in models 38. As expected, a may partly explain the puzzling finding of a (weakly)
higher rating factor, which implies a lower credit positive connection between our CSR indicator and
rating, results in a higher credit spread. Besides credit spreads.3
financial criteria, credit ratings also incorporate a On the other hand, the characteristics of the firms
host of non-financial factors and even confidential used in our two researched universes, i.e. investment
information (Crouhy et al., 2001). Therefore, as grade corporate bonds and socially responsible firms,
credit ratings already to some extent include gov- may be very different. We know from other studies
ernance, environmental and social issues, an extra that the compositions of equity indices for socially
CSR rating from a non-certified research agency responsible corporations possess pronounced funda-
does not seem to add informational value to bond- mental characteristics, often having a high propor-
holders. tion of so-called growth stocks (growth bias)
Furthermore, although issue-specific factors are of (Statman, 2006). As these are often relatively small
major importance, systematic sector-related risks and young firms which do not usually receive
(e.g. potential environmental disasters, regulation) investment grade ratings by virtue of their smaller
are also priced by credit investors, as shown by the size and more uncertain business prospects (see
mostly significant industry dummies. Interestingly, Deutsche Bundesbank, 2004, p. 19), these firms may
sector risks are not perceived to be highest in energy not be by majority in our sample, thus the results
(e.g. oil and gas) or basic resources (including could be affected. For this reason, we examined the
chemicals) where environmental issues with the rating distributions of the industrial companies that
potential to cause very high financial costs are were on the annually updated investment lists of
generally considered to be very critical according to SAM. Accordingly, many companies actually have a
results of Steger et al. (2007). Instead, apart from low credit rating (non-investment grade) or have
non-cyclical services, bondholders have the highest no credit rating at all from the leading agencies.
risk assessment for telecoms although these are However, these percentages are relatively low, for
generally perceived to be quite defensive. Especially example, in 2007 approximately 8% of the socially
due to their steady cash flows, however, telecoms responsible companies were non-investment grade
face above average event risks from LBOs and and 7.5% were not officially rated by the agencies.
M&A, leading potentially to higher bondholder Consequently, as firms with an investment grade
cautiousness. rating represent over 80% of the SAM universe, the
Although the superior importance of credit rat- distorting influence should be only moderate.
ings seems be the main reason for the minor rele- Finally, another possible explanation might be that
vance of CSR for bond pricing, there might be CSR is still largely ignored as a valuation factor by
further explanations for this finding. On the one bond investors. An evidence of the validity of this
hand, a limited informative value of the CSR indi- reasoning are the findings of Nelles and Menz (2008),
cator used in this study might be causal, because which suggest that even corporate governance is only
the SAM Research, amongst other things, states the slowly becoming considered as a valuation factor by
identification of corporates with a leading role in the bond investors. As corporate governance, however,
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 129

has been a subject of public debate since the scandals to scepticism and because they are not convinced of
at Enron, Worldcom and Parmalat and is nevertheless the positive effects on the risk-return characteristics of
only hesitantly being incorporated in investment their portfolios. This would be consistent with
decisions, it could be that this development is still modern portfolio theory, arguing that any constraints
imminent for the factor CSR. But possibly, bond imposed on the investment and diversification
investors consciously turn down the incorporation of opportunities entail a cost, especially for bond
the CSR criterion when screening because they re- investors who face quite different risk-reward char-
gard the diversification opportunities as being too acteristics than shareholders.
greatly reduced by the constrained investment uni- Although our puzzling results that socially
verse and are not convinced of the positive impact on responsible firms do not have lower cost of public
their portfolios with respect to risk-reward charac- debt are in line with previous research on share-
teristics (Geczy et al., 2005). holder performance that revealed no direct and
conclusive empirical evidence on whether high
CSR standards lead to lower cost of equity
Conclusions and implications (Renneboog et al. (2008), there are issues that
require further research attention. First, one possible
The interest in CSR has increased almost explosively explanation for the lack of influence of CSR on the
in recent years. The question of whether CSR has a risk premium may be a limited explanatory power of
positive impact on the company evaluation has, the CSR indicator used in this study. As we found
however, so far almost exclusively been analysed from no significant empirical link between our used CSR
the perspective of the stock market. In this article we measure and credit spreads, this may mean that the
therefore investigated the relationship between the SAM sustainability indicator is not a good proxy for
valuation of Euro corporate bonds and the quality of firms CSR, at least from the perspective of bond-
CSR of mainly European companies for the first time. holders. Therefore, we would recommend the use of
Generally, the debt market is of considerable impor- other CSR indicators (e.g. from Innovest, Oekom,
tance for corporate finance, which is the reason for Vigeo, or Eiris, to name a few) for further research.
the fact that creditors could generally play a significant Secondly, recent research shows that the usage of
role in the transmission of CSR into the valuation of aggregate CSR scores can have confounding effects
financial instruments. Because socially responsible as the composing dimensions are often imperfectly
corporations are often regarded as commercially more correlated (Scholtens, 2008). As we have not been
successful and less risky, they should have lower risk able to test the influence of CSR sub-scores on
premiums, all other things being equal. The results of governance, environmental and social performance
the empirical analysis show, however, that for a large due to data limitations, we would recommend
data panel of investment grade corporate bonds the further studies that fill this gap.
risk premium for socially responsible corporations These limitations in mind, the results of this
based on the classification by SAM Research was article nonetheless yield both practical and theoret-
ceterius paribus higher than for non-socially responsible ical implications. From a practical point of view,
firms. The different investigated models, however, ramifications concern both financial intermediaries
were only weakly significant in one case. Thus, by and regulatory bodies. Since it is quite uncontro-
and large an assumed relationship between CSR and versial that ecological, social and governance (ESG)
credit spreads must be rejected. One main reason is issues can have massive negative effects on firm
that obviously credit ratings matter more for bond performance, financial intermediaries (e.g. banks,
investors than CSR ratings. As credit ratings already pension funds, mutual funds) are well advised
to some extent include governance, environmental (or must be incentivized) to incorporate those non-
and social issues, an extra CSR rating does not seem to financial factors into their decision-making pro-
add informational value to bondholders. cesses. This is not only in their own economic
In addition, possibly credit investors consciously interest but also consistent with the fiduciary duty of
forgo a consideration of social, ethical and environ- bond investors and banks when social, ecological and
mental factors when making investment decisions due governance issues impact profitability and default
130 Klaus-Michael Menz

risks of companies to whom they lend. However, possibly leading to erroneous conclusions in empir-
the inadequate consideration of CSR by creditors is ical research. Secondly, the estimation results with
probably not due to a lack of interest in the theme the highly significant credit rating suggest that also
but due to a lack of comprehensive, comparable and future studies on the impact of CSR on equity
easily accessible data to evaluate the ESG perfor- performance should incorporate and control for
mance. In addition, not all financial institutions are different credit risks of researched firms. This aspect
willing to utilize the CSR rating of research firms is also in line with the growing amount of empirical
like SAM as this is costly and non-certified. In order literature revealing a significant impact of credit
to enable the incorporation, one of the most rating signals on stock prices.
important preconditions is therefore the availability Thirdly, with respect to more debt-specific issues,
of reliable, objective and low-cost information on it is remarkable that until now almost nothing is
the CSR performance of firms which allows for the known about the impact of CSR on loan perfor-
impact of various ecological, social and governance mance and corporate bond evaluation although most
factors to be diligently analysed and understood as of the external finance for companies is provided by
accurately as possible. As anecdotal evidence sug- banks and bond buyers. Therefore, in the future
gests, the company reporting of ESG performance is CSR research should focus more on the debtholders
currently differing considerably. This is especially perspective and less on shareholders due to the
inapprehensible since the Global Reporting Initia- considerable weight of debt in financing and the
tive (GRI), a large multi-stakeholder network of potential for transmitting CSR into debt pricing.
thousands of experts collaborating with the United Fourthly, more focus on the debtholders per-
Nations Environment Programme and United spective should also be interesting for researchers
Nations Global Compact, has developed an ESG because creditors presumably act differently from
reporting framework for worldwide application that shareholders regarding CSR, due to the different
serves as a means for improving the standardisation contractual rights and claims and therefore different
of company reporting. One main reason for the incentives and risk-reward-profiles of stocks and debt.
currently often unstandardized disclosure is that For example, under certain conditions the providers
reporting on ESG performance is still mainly vol- of shareholder funds profit from the execution of very
untary and therefore usually unaudited. Therefore, risky investment projects, since they harvest most of
regulatory bodies should rule public disclosure of the gains if it turns out well, whilst a failure would be
comprehensive and standardized reporting of ESG also at the expense of the creditors as they bear most of
information by all firms seeking access to public the costs. Referring to Merton (1974), defaultable
capital markets. The same should be valid for com- claims like loans or bonds can thus be characterised as
panies applying for loans at least for those surpassing having sold a put on the firms assets, whilst the equity
certain size limits. Lastly, financial industry bodies position can be imagined as being long a call on this
might work on a practical and easily implementable underlying asset value. Or as Alchian and Demsetz
tool for the quantitative and systematic evaluation of (1972) put it, bonds with their fixed claims are sold to
CSR, like for example the Excel-based Scorecard pessimists and stocks with a residual claim are sold to
for German Corporate Governance developed by optimists. Therefore, debtholders perspective on
the German Society of Financial Analysts (DVFA) CSR implies a more downside oriented view, in
based on a code of best practice. contrast to stockholders who have also the prospect of
Furthermore, there are manifold theoretical a huge upside in share prices. One important impli-
implications that the results of this article generate. cation of this different view concerns the most
First, the finding that unobserved heterogeneity appropriate CSR screening approach from a debt-
plays a significant role when investigating the rela- holder perspective. In contrast to a stockholder view,
tionship between CSR and financial firm perfor- where a best-in-class rating filter might be adequate,
mance as measured by the credit spread should be of providers of debt are presumably less interested in
general interest for CSR researchers. This is gener- engaging in the 10 or 20% most socially responsible
ally important since spurious correlations could companies but more keen to avoid the worst in
emerge due to unobserved company characteristics class, i.e. those firms that have the highest potential
Corporate Social Responsibility: Is it Rewarded by the Corporate Bond Market? 131

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