Greater diversity, innovation and impact means bond buyers have plenty to consider when satisfying investment goals.
Green bond issuance has followed a stellar growth trajectory since the year the Paris Agreement was signed. According to Refinitiv, around US$40 billion of green bonds were launched in 2015 while, to mid-August this year, some US$250 billion of new borrowing has already been concluded. Facilitating the market’s expansion has been a quest for transparency and standardisation, brought through efforts such as the ICMA Green Bond Principles, the EU taxonomy and preparation for impending regulatory disclosure requirements.
The same standards are transposed across other sustainable fixed income products, such as social bonds, which have become another major asset class for ESG investors. Supply of social bonds increased massively in 2020 during Covid-19 – as governments and corporates looked to raise funds to support recovery and access to healthcare and housing – rising from just under US$14 billion in 2019 to over US$160 billion. Demand for social bonds did not come at the expense of green bond buying, reflecting the level of underlying interest in ‘use of proceeds’ ESG bonds, which finance specific, ring-fenced projects.
Syndicated ESG lending volumes are also increasing. And it is innovation in the loan markets that has led to the emergence of sustainability-linked bonds (SLB), instruments with coupon payments linked to pre-determined sustainability targets at the corporate level. Interest in these bonds, is growing.
“We saw the first sustainability-linked loans back in September 2019, and since then the market has grown to a point where there’s more talk now about sustainability-linked than about use of proceeds instruments,” said Michael Wilkins, Managing Director, Sustainable Finance at S&P Global Ratings. “That’s not to say issuance from the use of proceeds side has diminished, it’s just that interest in sustainability-linked has grown to match it.”
Over the last 12 months, SLBs have contributed around US$60 billion to an ESG bond universe that now has a range of products that fund projects addressing climate and social issues as well as finance corporate transition to a low-carbon economy.
Addressing the climate imperative and ongoing social objectives will see sustainable debt volumes escalate.
“We were looking at around US$530 billion in total sustainable bond issuance in 2020,” said Lori Shapiro, Sustainable Finance Associate at S&P. “And this year we’re looking at exceeding US$1 trillion. That’s essentially a doubling of the market and the largest absolute increase in issuance volume to date.”
Impact and influence
Developments in ESG bond markets have not only resulted in a broad array of fixed income product but they have also brought borrowers and lenders closer together. Bond buyers that traditionally assessed investment from a credit perspective also now demand detailed insight as to what their money is financing and to what impact. They are also exerting influence over the behaviour of companies they finance as long-term sustainability is a credit positive. It is another point of pressure for ESG investors.
“As a fixed income investor, you can make a difference,” said Bram Bos, Lead Portfolio Manager for Green Bonds at NN Investment Partners. “In the past, equity was seen as the best way of engaging with a company, through voting, attending annual general meetings, etc. But companies and governments also need funding in the end, right? We should try to have impact as investors from as many angles as possible.”
Impact can readily be assessed by green or social bond buyers thanks to improvements in transparency, measurement and reporting. Use of proceeds bonds, however, are the domain of a select group of issuers with project portfolios large enough to be financed in the bond markets.
This issuer base may have broadened from its mainly supranational beginnings to include corporates, financials and, increasingly, sovereign borrowers, but the average credit rating of bonds remains investment grade.
“It used to be a double-A rated credit market but now it’s probably high single-A which implies there’s been more industrials, more energy companies coming to market recently,” said Mitch Reznick, Head of Research & Sustainable Fixed Income at Federated Hermes.
It will take a while for average ratings to fall further.
“We do see a little bit more interest in the high yield sustainable space, but the market is lagging,” said Bos. “A lot of companies issuing high yield are smaller, private companies that may not have the resources available to set up a green bond framework or define ESG policies.”
Smaller companies can issue sustainability bonds targeting a mix of social and green projects, which will accelerate the trend. They also have access to investors willing to support their transition to a more sustainable business model.
Transition bonds were once tipped to become a major feature of the ESG bond market, but the format has not caught on.
“Talk of transition bonds has faded into the background,” said Bos. “Two years ago, there was talk they would cater to companies operating in the ‘light green’ area of the economy, but it felt a little bit dishonest. For me the label does not exist. I believe we should not invest more time trying to build a transition bond market when we have to take meaningful steps to tackle climate change. We believe issuing a green bond is more credible and will have the impact we want to see.”
The focus of transition finance has, instead, moved to SLBs. Structures for these have coalesced around the borrower paying a step-up coupon, based on hitting specified key performance indicators (KPIs). But there is plenty of debate about how the market should work.
Questions centre around the ambitiousness of KPIs, the size of the step-up, whether the step-up should take the form of higher redemption payments or whether missing targets should be offset through carbon credit purchases. Even the direction of the step is up for debate.
“You ultimately want companies to hit their targets but is penalising them on that transition path fair?” asked Bos. “I think a step-up coupon gives a wrong signal because it implies you’re punishing companies for not hitting targets, whereas they should be rewarded when they reach them. After all, if a company reaches a target, then it means it is less exposed to ESG risks, and so justifies paying a lower coupon.”
Although SLBs have become more prevalent, they have yet to be widely embraced by investors. They do not fit into a pure green bond strategy, rather they provide an ESG overlay to regular credit.
“When we buy such a bond, it will be because we like the issue from a credit point of view, and also because we like the ESG profile of the company but not specifically for the SLB structure,” said Bos.
Further, if the company has committed to reach SLB targets, then exposure to its performance can be gained through conventional bonds.
More generally, a multiple approach to assessing an issuer’s ESG credentials is common with debt investors for any instrument.
“We have a three-tier framework when looking at green bonds: an ESG assessment at the issuer level; the quality of governance in the green bond framework; and transparency and impact at the asset level,” said Stephanie Maier, Global Head of Sustainable and Impact Investment at GAM.
A transparently green future
In an interesting quirk of market development, green bonds have provided issuers with slightly more favourable borrowing terms compared to conventional curves. The ‘greenium’ mostly reflects supply/demand dynamic at play, rather than representing a discounted view of future sustainable outperformance. The mass of ESG funds clearly outweighs the supply of suitable assets, so giving up a few extra basis points is a minor issue for investors taking a long-term view on sustainability. The market’s outperformance during periods of volatility, such as experienced at the height of the pandemic’s initial outbreak in March/April 2020, is also a short-term attraction.
“You could look at the greenium as an insurance payment,” said Nordea’s Head of Sustainable Finance Advisory, Jacob Michaelsen. “If you could buy a bond paying two or three basis points more than the conventional curve, but the bond outperforms by 30 basis points during volatility then there’s a payoff of a factor of 10. I’d take that any day of the week.”
Underlying demand for ESG bonds is only likely to increase, particularly as the effects of climate change become more apparent. Supply will also improve as the market makes issuing ESG bonds more straightforward and rewards companies with a sustainable agenda – and then there’s the greenium.
“The greenium makes it easier for a treasurer to make a case for a green bond to finance a specific project,” said Reznick.
As with any rapidly growing market, ESG bonds are tormented by concerns about transgressions. Nevertheless, an adherence to transparency and the threat of damage to reputations from any signs of green or social washing may be sufficient to keep markets credible. For Michaelsen, meaningful impact on the economy and environment is the main issue, not greenwashing.
“I’ve never been overly concerned with greenwashing,” said Michaelsen. “Because standards in the market are based on transparency, you will very quickly be called out for any misdemeanour. I’m more concerned with the lack of action.”