The rising costs of the Covid-19 pandemic have sparked rapid growth in a new niche in the ESG debt market, but how sustainable are Covid bonds? Mona Dohle reports.
Who looks after children when schools are closed and parents are supposed to be working? How do we as a society care for our elderly? Are our healthcare systems viable? Which jobs really are essential and must continue when everyone else is staying at home? Can small businesses survive the lockdown without defaulting? Are we facing mass unemployment?
The Covid-19 pandemic has not just ground the global economy to a halt, it has also opened up a barrage of pressing social questions. Most of these challenges have already been present but persistently ignored, much like a leaking tap that eventually turns into flooding.
The damage caused by the virus has sparked an unprecedented demand for capital. Healthcare infrastructure, the development of new vaccines and medication will need to be funded while service-oriented businesses are struggling for a financial lifeline.
Just as the virus originated in China, Chinese capital markets were also first to respond to the crisis. In mid-February, there was already a flurry of domestic Chinese bond issuances underway, contributing to funding a multitude of Chinese firms, from pharmaceuticals to car plants.
The “virus bonds” were given a regulatory fast track process to speed up the issuance and help alleviate the immediate impact of the crisis. At the same time, only a tenth of the proceeds had to be allocated to containing and preventing the pandemic, according to China’s regulator, the National Association of Financial Market Institutional Investors (NAFMII).
Issuers include airlines, glass manufactures and even pig meat producer Muyuan Foods, which pledged to ensure adequate meat supply in the midst of the crisis.
By the end of March, NAFMII said it had supported 193 domestic issuers, raising a total of Y173.3bn (£19.2bn). In late February, the Bank of China started taking Covid-bonds offshore by launching a two-year dual currency bond through its Macau branch, the first social bond issuance by a Chinese issuer targeting international investors, according to law firm Allen Overy, which advised on the transaction.
As the virus spread across the globe, so did the Covid bond label, which soon turned out to be a popular new strategy to market fixed income products, from corporate- to emerging- and frontier market debt.
Measuring the size of the market is proving to be difficult. Research by one asset manager puts it at more than $65bn (£51.5bn) and predicts that it will hit the $100bn (£9.3bn) mark, if current issuance levels continue. Another asset manager contradicts this by estimating that the market has already exceeded $150bn (£119bn) in early June. No matter the confusion, this is a big market considering that it did not exist at the start of the year.
Issuers now range from the Republic of Indonesia to the Nordic Investment Bank and the African Development Bank. Covid bonds tend to fall under the broader label of social bonds which has received growing popularity in recent months.
While issuance levels of green bonds slowed in the immediate aftermath of the crisis, the supply of social and sustainability bonds increased sharply, with the combined social and sustainability bond issuances overtaking green bonds for the first time in April, according to Refinitiv. But as the case of issuances in China illustrates, the use of proceeds is far from straightforward and not all Covid bonds fall under the social bond label.
The most common framework for social bonds are the International Capital Market Association’s Social Bond Principles, which specifically mention that all designated social projects should provide clear social benefits, however, the principle also leave scope for refinancing operations. More importantly, these principles are not legally binding. In the context of the pandemic, this has actually been an advantage for issuers as it has offered flexibility to issue bonds without regulatory obstacles.
This growth in demand for social debt has been tangible for Kevin Ranney, director advisory services at Sustainalytics. The ESG ratings provider has established a taxonomy of ESG bonds, distinguishing between healthcare and socio-economic impact mitigation themes. “We have certainly seen considerable growth in bond issuance which fell on Covid 19.
“Social bonds in general tend to see less issuance than green bonds but proportionally speaking we have seen a significant increase on the social side,” Ranney says. “The issuance has predominantly come from development banks although there has also been some corporate issuance.”
For institutional investors, pension funds in particular, Covid bonds have a lot to offer. As the industry continues to gravitate further towards fixed income assets, with 47% of all defined benefit (DB) assets invested in bonds, according to the Pension Protection Fund’s purple book, investors are on the hunt for debt that offers a relatively higher and uncorrelated return with sustainability credentials. But why are Covid bonds offering higher yields and do these profits not stand in the way of the supposed sustainability of the asset? Are the proceeds really helping to tackle the pandemic or is all this just virtue signaling in an already heavily distorted fixed income market?
One key obstacle for many investors is that due to the novelty and complexity of the investment strategy, the use of proceeds tends to be harder to measure as it would be with traditional social bonds, which in turn means that investors in purpose-led debt often cannot participate.
In a fixed income market that is more distorted than ever due to unprecedented levels of central bank intervention, assessing the credit worthiness of a new asset can be complex, as Stuart Trow, credit strategist at the European Bank for Reconstruction and Development warns. “Both issuer and investor have to do quite a bit of credit work. That’s why there were relatively few green bonds early in the crisis as few investors or issuers had the bandwidth to deal with anything novel. It was far easier for them to deal with established names for which they might already have approvals for.” This meant that pension schemes with limited credit research capacities were initially hesitant to embrace the new trend.
But Ranney argues that there is room for maneuver. “Given the urgency of the crisis, institutional investors in general are tending to be slightly more relaxed about Covid-related social bonds.
“However, it is still important for them to establish the credibility of the bond, to ensure that there is a clear social bond framework that has the ICMA elements, to ensure that there is a plan to be transparent about the use of proceeds.
“Institutional investors should also be looking for a second party opinion for each bond framework or issuance but it’s reasonable to be patient, and I think that is the case for many of them. If the second party opinion comes a bit later, sometimes after the issuance, that is likely to be ok for many industries” he adds.
Indeed, some of the world’s biggest pension funds have been quick to embrace the trend. Examples include €514bn (£461bn) Dutch pension scheme ABP, which as of early June had just under €500,000 (£451,500) invested in Covid bonds.
“We started investing in Covid bonds in mid-March, and as of early June, we had just over €500m (£451.5m) invested as part of our broader ESG bond portfolio. It should be added that we already had a significant amount of money in ESG compliant bonds. By the end of 2019, we had some €7.6bn (£6.8bn) invested,” says Asha Khoenkhoen, a spokesperson for the scheme.
She distinguishes between two main stages of the investment, which is focused on AAA-rated bonds issued by development banks and with a maturity between that falls between two and 10 years. “The initial round of investments was dedicated to funding the temporary expansion of healthcare facilities, the second round of funding will now focus on how to get the economy going again and to support SME businesses struggling with the effects of the lockdown,” Khoenkhoen adds.
Another pension scheme which is likely to have exposure to Covid bonds but doesn’t disclose its individual holdings, is Japanese pension giant GPIF, which by the end of last year managed some ¥159trn (£1.1trn) in assets. The scheme has recently launched initiatives to support ESG bonds with 10 multilateral development banks and four development financial institutions. This includes social bond initiatives with the European Investment Bank, the World Bank, the European Bank for Reconstruction and Development and the African Development Bank, all of whom have issued Covid bonds.
A spokesperson for GPIF told portfolio institutional that there was a possibility of the pension giant being invested in this market, provided the underlying assets had a AAA-credit rating and were in line with ICMA principles.
Closer to home, government workplace pension scheme NEST also holds Covid bonds. Anders Lundgren, NEST’s head of public markets and investment strategy, confirms that there has been a notable uptake in demand. “We’ve seen a recent increase in the issuance of social bonds with proceeds earmarked for pandemic-related purposes.
“While the majority of these have come from supranational or government-related agencies, there have been those issued by corporations too,” he adds.
The issuance of Covid-related bonds should increase in the coming months as various issuers look to meet unique financing needs created by this pandemic. These bonds have the potential to generate competitive yields while also helping to meet the financing needs created by the virus,” he adds.
NEST has been able to mitigate the need for additional credit research by investing through two externally managed fixed income funds as part of its default portfolio. These investment-grade fixed income funds are among others invested in Covid-19 bonds issued by Bank of America.
“The proceeds will be allocated to health care industry lending in the firm’s global commercial bank, specifically not-for-profit hospitals, skilled nursing facilities and manufacturers of health care equipment and supplies,” Lundgren says. Yields for the Bank of America bond exceed benchmark treasuries by 1.3%.
Beware of bluewashing
Given the ambivalence of a Covid bond, the question arises how far issuers can push the concept before they start being accused of “bluewashing”, the social bond equivalent of greenwashing.
Institutional investors might want to consider carefully to what extent the refinancing of a meat factory or an airline could be seen as playing a part in tackling the pandemic, rather than being a bog- standard corporate bond investment. Given the more stringent ESG reporting requirements for UK pension scheme trustees, awkward questions may have to be answered.
Andy Cheseldine, a professional trustee at Capital Cranfield, warns that investors should bear in mind that Covid bonds are not necessarily social bonds. “There are a lot of, dare-I -say, weasel words around Covid bonds,” he warns.
Nevertheless, if chosen wisely, Covid bonds could offer diversification potential. “Assuming they have been properly structured, Covid bonds should be well uncorrelated with markets,” adds Kevin Wesbroom, who is also a professional trustee at Capital Cranfield.
Dutch pension scheme ABP attempts to prevent bluewashing by only investing with development banks.
“These banks have a completely different setting than corporate bond investments. They have been established precisely to offer financial support,” Khoenkoen says. “They also have extensive reporting requirements.”
In addition, ABP’s administrator, APG, has set up a framework in collaboration with PGGM, which with €238bn (£215bn) in assets makes it the second largest pension fund in the Netherlands. Both asset owners have launched an AI-powered platform to test ESG investments based on the United Nations’ Sustainable Development Goals. The initiative, which is a collaborative effort open to pension schemes around the world, could also be a useful measure for UK schemes to assess the validity of their ESG investments. USS is one of the UK schemes interested in the screening process, according to David Russell, head of responsible investment at the £66bn scheme.
Assessing credit risk
Another key factor to bear in mind is the potential for default risks. As the costs of the pandemic are rising, so is the likelihood that some issuers might not be able to pay back those loans.
Emerging markets are home to some of the main Covid bond issuers, but many countries are now on the brink of another sovereign debt crisis. An indication of that is the fact that the IMF has granted $500m (£402.7m) of debt relief to 25 frontier markets struggling with the costs of the pandemic, and debt suspensions in more than 100 emerging and frontier markets.
Moreover, a recent default by irrigation company Jain Irrigation Systems in India on some of its green bonds highlights that investing ESG-compliant investing does by no means equate to a risk-free portfolio.
One example of the rising sovereign debt risks for emerging markets is Ecuador, which sold $400m (£322.3m) of social bonds with a maturity of 15 years at the beginning of this year. That debt is now trading at yields above 7%. The South American republic has also agreed debt suspensions with the IMF on some of its loans. If Covid-19 does contribute to more widespread defaults among emerging markets, pension funds might find themselves in the difficult situation of having to pressurise already-cash strapped nations for repayments, or risk losing their member’s money.
Khoenkhoen also stresses that given the scheme’s mandate to safeguard member’s money, investing in social bonds should not be equated with charity. “Social investments do not mean that we give up on returns,” she says. “We are an active investor and are looking for investment opportunities which offer the right-risk return balance.”
Cheseldine agrees that investors need to tread carefully when looking to buy Covid bonds. “Investors need to be clear on the potential default rates. You can’t just say blindly that Covid bonds are going to be good, you need to look behind them and who is offering them,” he adds.
Wesbroom says that getting good quality advice is crucial here. “Investors will need an adviser who can help you understand the structure of the bonds.
“You will need somebody that can help you understand in depth of the truth behind that, and the likelihood of future claims, otherwise these things are wonderful investments but you have a very small marginal return for quite a long time until it’s suddenly game over. And then you’re wiped out if you’re not careful,” he adds.
How durable will the trend towards social and sustainability bonds be? If scientists and policy makers manage to get the effects of Covid-19 under control, the setting for social bond issuers could change dramatically. Given that most Covid bonds tend to have a shorter maturity, is there a chance that the trend might blow over before it has really started?
Khoenkhoen stresses that the growing interest for social bonds has already preceded the crisis, but that the pandemic has played an important role in consolidating the importance of social bonds. “The SDG framework has helped institutional investors to visualise which social and sustainability bonds can be assessed, making investors increasingly open to the asset class,” she adds. “We hope that by publicly talking about our social bond investments we can generate a domino effect and encourage other institutional investors to join in.
“Ultimately, we are all collectively responsible for sustainable development.”