Interview

New Horizons for Green Bonds

David Zahn, Head of Sustainable Fixed Income at Franklin Templeton, says new standards and innovations are expanding the supply of green bonds to meet increased investor demand.

Investor demand for green, social, sustainability-linked and transition bonds (GSS+) continues to rise rapidly, outstripping supply. In fact, demand for green debt has been on the up since market inception, with more than US$1.6 trillion issued to date, according to the Climate Bonds Initiative’s (CBI) latest Green Bond Pricing in the Primary Market report. 

The shortfall in GSS+ supply is driven by a myriad of factors, with a major one being the need for issuers to establish and use frameworks for green and social bonds that clearly articulate the proposed use of proceeds.  

The International Capital Market Association’s Green and Social Bond Principles seek to support issuers in financing environmentally sound socially responsible projects, with them widely, but not universally, adopted. 

“Those take time and are quite intensive to do,” says David Zahn, Head of Sustainable Fixed Income at Franklin Templeton Fixed Income. “There’s a lot of legal work involved, and you also have to obtain third party opinions – all of that just takes time.” 

The fact that green and social bonds are use of proceeds instruments, meaning that the funds are dedicated to financing green projects, limits their supply, according to Zahn, as it requires issuers to have a set of projects available for capital allocation which meet specific criteria.  

“Sometimes companies are willing to issue these bonds, but they can’t get the projects done quickly enough,” Zahn tells ESG Investor. “This, in turn, means that there may not be as many bonds coming to market.”  

Further, most green bonds are issued by larger issuers. Since green bond proceeds are ring-fenced for specific uses, if a company wishes to issue a €300 million green bond, the issuer must have €300 million of green projects.  

“For smaller companies, this is particularly challenging because they may not have the necessary balance sheet to support such a large issuance,” says Zahn. 

Diversify and multiply 

Green bond issuance, however, is set to rebound this year, after a tough 2022 across fixed income markets, amid supportive policy developments, including US President Joe Biden’s Inflation Reduction Act – which will provide around US$386 billion in energy and climate spending over the next 10 years – and China’s Green Bond Principles, published in July last year, which are more aligned to international standards and practices.  

Compared to most fixed income markets, green bond issuance is predominantly European, with the continent the highest-contributing region to sustainable debt globally (41.7%). Europe’s dominance in the green bond market, however, is being challenged as Asia-Pacific supply continues to rise, driven in large part by China. Issuance of internationally-aligned green bonds the region hit US$39.15 billion in Q2 2022, up from US$29.44 billion in the same period the previous year.  

Overall, the bond market is in good shape,” says Zahn, adding that one of the misnomers that occurred last year is that green bonds underperformed conventional bonds. 

“This was simply because green bonds have a much longer duration. Therefore, when yields rise, the impact is more significant, resulting in a larger loss,” he says.  

“However, considering that we believe we are nearing the end of the rate hiking cycle, now is probably a good time to consider including green bonds in your portfolio because they do offer the advantage of a longer duration.” 

A recent report by JP Morgan Asset Management compared the Bloomberg Global Aggregate Index and the Bloomberg MSCI Global Green Bond Index, noting that although the green bond index has a higher credit quality, it has underperformed and has been more volatile than its non-green counterpart since its inception. However, the report cited its longer duration (7.2 vs. 6.8) which weighed on the relative performance of the green bond index as yields rose in 2022.  

Innovations and opportunities 

The green bond market has continued to evolve and innovate in recent years. Germany entered the market in September 2020 with a €6.5 billion (US$7 billion) syndication under its twin bond concept, meaning a green bond was issued with an identical non-green counterpart.  

“In this case, the green bonds have the exact same coupon and maturity as the conventional bonds, allowing investors to see precisely how much extra they are paying for the green aspect,” says Zahn, adding that in most other cases there is a “maturity mismatch”.  

The twin-bond approach enables the sovereign issuer to achieve two key objectives: responding to investor demand for green bonds benefiting from the highest liquidity in the secondary market, while also building a complete benchmark green yield curve in short order. 

Another significant development in the past 12 months, according to Zahn, is the emergence of sovereign issuers issuing short-dated green bonds.  

Given strong appetite for green bonds, outstripping supply and leading to over-subscription, the expansion of sustainable debt into short-term markets can help to further raise issuance volumes, with the CBI predicting US$5 trillion in annual green finance by 2025.  

In May of last year, Austria became the first sovereign issuer to include short-term debt instruments like treasury bills (T-Bills) and commercial paper in its green debt programme, issuing €1 billion of new debt to attract shorter-term investors to finance environmentally beneficial projects. 

“Normally [sovereign] issuers tend to issue longer-dated bonds,” explains Zahn, adding that Austria’s first green T-Bill signifies another positive development in the green bond market, with these collectively indicating growing maturity. 

“Some of the hesitation towards green bonds stems from them being perceived as longer duration assets,” he says, noting that this perception, until recently, left some investors unsure about including them in their portfolios.  

However, recent developments have helped to shift investors’ perspective.  

The emergence of sovereigns issuing short-term green bonds also expands the range of issuers in the market, he says, adding that with more sectors participating, the green bond market has become more developed, allowing investors to incorporate them into both conventional and dedicated portfolios, fostering sector allocations and exposure management. 

“It appears that interest is returning to green bonds after a period where they were deemed less attractive,” he says, adding that the asset class is gaining “renewed attention”.   

Setting standards 

In March, the European Council and Parliament reached an agreement on a voluntary standard for EU green bonds, requiring issuers wishing to obtain the stamp of approval to ensure all proceeds are invested in economic activities which are aligned with the EU taxonomy, provided the sectors concerned are already covered by it. 

The EU Green Bond Standard provides us with a platform to initiate discussions about what constitutes green and what doesn’t,” says Zahn, noting that not everyone agrees on the inclusion of certain elements in the standard and will require an iterative process of refinement over time.  

While the standard is not flawless, he says, it does demonstrate the complexities involved in defining what is truly green.  

“Even within Europe, there are disagreements,” he says. “For instance, nuclear power may be considered green by some, while others have concerns about its negative aspects. 

“In Germany, nuclear power is generally not viewed favourably, whereas in France, it is embraced as the primary solution. This diversity highlights the challenges faced in reaching consensus,” he adds.  

Bondholder stewardship 

Speaking to ESG Investor, Stephanie Maiers, Founding Global Steering Committee Member at Climate Action 100+, emphasised the significance of responsible investors recognising their stewardship roles as holders of debt and equity in driving the transition towards sustainability. 

Zahn echoed her sentiments, noting that investors must utilise different leverage points, especially in hard to abate industries like steel, cement and oil and gas, with fixed income investment arguably having an even greater impact in the net zero transition than equities.  

“This is primarily due to the sheer size of the fixed income market, which surpasses that of the equity market,” he says. “This factor alone makes it a significant leverage point.” 

The global fixed income market is valued at around US$130 trillion. By comparison, the global equities market is worth approximately US$42 trillion.   

Additionally, the fixed income market presents numerous areas where engagement is possible, encompassing different points in the capital structure of companies, private entities that lack equity holders, and engagement with sovereigns, says Zahn.  

“Engagement with sovereign entities is particularly noteworthy, as they establish the rules and policies that guide corporations in their sustainability practices,” he says.  

“By being involved as fixed income investors, we can interact with a broader range of touch points. Consequently, I believe that the potential impact on driving positive change is higher for fixed income investors compared to equity investors.” 

In June, the Institutional Investors Group on Climate Change published its bondholder climate stewardship guidance, which it described as a “major step” towards progressing and framing bondholder stewardship – and seizing of the opportunity for corporate bondholders to progress real-world emissions reductions.   

“Anything that brings standardisation to bondholder engagement is a step in the right direction,” says Zahn, adding that bondholder stewardship guidance is helpful for the market.  

“The more we all talk the same language, the more the issuers will pay attention.”

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