Green money

1 Jun 2021

Demand for sustainable debt is growing. Mark Dunne looks at how ESG is influencing the bond markets.

Rishi Sunak is turning green. The chancellor intends to issue a green sovereign bond later this year to fund projects that tackle climate change, improve the UK’s infrastructure and create “green jobs”. It will also, he says, meet growing investor demand for sustainable debt.

Indeed, some would argue that ESG has become a mainstream strategy for picking equities, but it also appears to be establishing itself as a method of assessing risk in the bond markets. “ESG is everywhere, including fixed income,” says Matthieu Guignard, global head of product development and capital markets at Amundi ETF. “It started with equities, but now almost all the market is switching to ESG, including fixed income.”

The global sustainable debt market is worth close to $3trn (£2.1trn), the Institute of International Finance says. The $315bn (£226.6bn) raised in the first quarter is almost half of the total amount collected during the whole of 2020, showing how fast the market is expanding. “Sustainable debt issuance is growing quickly and we believe is becoming an attractive asset class in its own right,” says Eric Nietsch, head of ESG Asia at Manulife Investment Management.

In 2020, the amount of sustainable debt issued by companies in the Asia Pacific region has more than doubled over the past five years.

“We believe this is driven by increasing awareness among companies of their ESG risks, recent and anticipated regulatory changes, and a recognition that it can be helpful for issuers to diversify their funding sources,” Nietsch adds. ESG’s growth in the bond market is not a surprise for one man.

“Equity is a small fraction of the financial markets. The reality is that most assets are in the fixed income space,” says Felipe Gordillo, a senior ESG analyst at BNP Paribas Asset Management. “Our clients are moving into ESG integration and they want to see solutions, and not just in equities.”

ESG is establishing itself as a crucial part of investment decisions on equities, so why not use it in other asset classes. “Alongside price, operating risk and financial risk, ESG is part of the core investment process,” says Mitch Reznick, head of sustainable fixed income at Federated Hermes.

“There are no longer clients who ask: “Do you do ESG? They are asking specific questions around carbon foot-printing, around sustainable activities and controversies,” he adds. “They are more sophisticated and that is bringing asset managers along with them.”

Other options

Yet green bonds are not the only way to make bond portfolios sustainable. Other bonds that seek to fund specific projects have emerged, including sustainability-linked bonds, social bonds, transition bonds and blue bonds, which focus on ocean conservation. ESG in the bond market is stretching beyond labelled bonds with issuers of traditional debt being questioned by investors on their ESG policy.

“It does not have to be labelled for us to like a bond’s ESG credentials,” says Scott Freedman, a fixed income portfolio manager and credit analyst at Newton Investment Management. “It is looking at the E, S and G credentials of an issuer, and the extent to which it considers the material risks of its impact on society and the environment. Is the bond achieving good outcomes without having to be labelled?

“There is more breadth in how you build a sustainable-bond portfolio. Not just through labels, but via the credentials of the issuer, too,” Freedman says.

So, sustainable debt is not just about green bonds. “There are several paths to building a sustainable bond portfolio,” Reznick says.
Another avenue is that sustainable bond investing is not just for active managers.

“Green bonds are a specific option, but it is only part of the environmental approach to ESG,” Guignard says. “Generic indices also adopt an ESG approach by applying the same recipe that can be applied to equities.”

Around a third of fixed income ETFs in Europe were based on ESG indices last year, according to Amundi.

Picking a winner

“The direction of travel that a corporate or sovereign intends to take is important in a sustainable approach to fixed income investing,” says Giulia Pellegrini, a senior emerging market debt portfolio manager at Allianz Global Investors.

When it comes to ESG, expectations from asset owners have stepped up, Pellegrini adds. “Climate and social issues have become more important for our clients since last year. As a result, we are keener to come up with options to satisfy that demand,” she adds.

Alongside its traditional debt funds, which include ESG integration, Allianz has a range of stricter products that exclude certain names and it is developing an impact investing offering.

“That will be the new normal going forward,” Pellegrini says. “It is starting from a low base, so I would not call it mainstream. I would call it necessary, or clients will not talk to you.”

Yet assessing a bond’s ESG credentials may not be as hard as it seems. “People separate equities and fixed income into different approaches, but in a lot of cases you are looking at the same companies,” says Madeleine King, who leads the investment grade research team at LGIM. “So, as much as each asset class has its idiosyncrasies there is a lot of commonality.

“There is not that much differentiation in how we look at ESG for fixed income and equities,” she adds. King’s colleague Jonathan Lawrence, who is an ESG research specialist, says: “Irrespective of a bond’s label, investors are exposed to the balance sheet and cash flows of the issuer. Therefore, you are exposed to the same risks as when buying a normal bond.

“When we construct a portfolio, it is important to invest in companies which are taking sustainability seriously, even when participating in the vanilla bonds of a good ESG company as opposed to buying green bonds of a weaker ESG company,” he adds.

This is a big issue when assessing the sustainability of a bond. “Not all green bonds labelled green are deserving of the label,” Nietsch says, explaining that they have decided not to invest in some green bonds due to concerns relating to the company’s framework.

“We look for the project that the debt is funding to have credible alignment with climate science and that the issuer is transparent about how they are using the proceeds.

“You have to assess what an issuer is doing overall. Although you can get some comfort around a project that a green bond is funding, you have to be careful that other parts of the balance sheet are not being used to expand its overall emissions,” he adds.

Reznick agrees that bonds should be assessed at the corporate level. “The labelling is important from a communications point of view, but it is about the companies you invest in that shows how the portfolio is indemnifying itself against the risk of climate change.

“Green bonds are necessary but not sufficient – you need change at the corporate level, which has an impact on all securities in the cap structure, not just project based. It can magnify the positive impact of companies change at the corporate level as opposed to the project-based level,” Reznick adds.

What’s it worth?

It is a question as old as the concept of sustainable investing and people are still asking it: does buying green mean making less money?
“There is always the question of who gets paid for being green – the investor or the company? asks Nietsch.

“It is becoming reasonably established that there is a premium for issuing green bonds in that they tend to price a little tighter than non-green issuances.

“That does not necessarily mean lower returns. We believe green debt can help companies become more resilient and we have not seen many green bond defaults. This debt can contribute to de-risking a company, so it can provide an attractive risk-return profile, which we believe, could enhance returns over the long term.”

When it comes to green bonds, Freedman sees a slight spread premium, or a ‘greenium’, to vanilla bonds, making it clear that he is talking low single digits.

“Labelled bonds are stickier capital,” he says. “There are less sellers during times of crisis, so they hold in better during less favourable periods for fixed-income markets.”

There is a danger that investors could pay too much attention to yields, where there are other factors to consider. “The question of return from the bond asset class is more a question of risk. The higher the risk, the higher the return should be,” Guignard says.

“There is no structural reason why green bond returns should be higher or lower than other bonds,” he adds. “It depends on the risk that is embedded in those bonds.”

The growth of the market shows that investors believe they can make an adequate return for the risk taken. “The majority of green bonds come to market priced at the same level as conventional bonds,” Gordillo says. “If they were more expensive in the primary market, we would not have the multi trillion-dollar market we have today. Only investors with an impact mandate would buy them.

“One of the successes of the green bond story is that a portfolio manager, in most cases, will be indifferent to buy green or conventional debt. That means volumes in terms of capital allocation for these transactions.”

Gordillo continues to explain that the “greenium” is small in the secondary market and is more visible in euro-denominated transactions. Europe has more buy-and-hold investors, which creates less liquidity therefore driving markets down, but he makes it clear that transactions in primary markets are not more expensive.

This increases if a green bond is issued from another part of the market. “There is a demonstrative “greenium” in some of these securities, which can be a little more pronounced when you are in some of the brown industries,” Reznick says. “There is greater demand here because if you are building a diversified sustainable portfolio, it is difficult to include the brown industries, which have an element of cyclicality in them. But if a brown industry company issues a green bond, you obtain the diversification and sustainability bene t from the debt.

“As a result, they can be overbought because no one wants to sell them,” Reznick adds. Ultimately, when it comes to the return, it is equal to the risk taken. “A good ESG company is a company with lower risk,” King says. “Risk and reward are linked in bond markets, and so strong ESG companies tend to trade tighter than problematic names.”

We can work it out

Creditors do not get a vote at AGMs, so the influence they have over a corporate may not be as strong as it is for shareholders. But where bondholders could be effective is by refusing to lend money to corporates, especially as they typically make several visits to the bond markets. “We can influence the cost of capital,” Freedman says.

“In terms of who has more power – the lenders or the issuers – it ebbs and flows depending on the conditions in financial markets,” he adds.
Issuers typically need to re nance their debt when it matures. “This is a crucial moment to share with issuers our expectations on their climate change actions or if we are unconvinced by their sustainable strategy,” Gordillo says.

Reznick has had similar experiences. “Engagement is also effective when companies have a recurring presence in the capital markets. In the case of fixed income that is annually. It is almost like a recurring IPO as they approach the market to re nance existing debt,” he adds.

So, there is a point when a bondholder has influence over a corporate’s board. “Timing is crucial when working to make issuers more sustainable,” Nietsch says. “The conversations that happen before issuance are when we have the greatest influence.” Newton has been working closely with a couple of issuers to help them understand what constitutes best practice in ESG, and to enhance and refine their ESG disclosures and reporting.

“Bond issuers recognise they have to be more accountable, and therefore they are more open to hearing input from investors. Ultimately, that communication will improve the sustainability of issuers and their unlabelled bonds,” Freedman says.

For some, bondholders have as much right to a say in how a corporate is run as shareholders do. Voting should not come into it. “The right to engage with a company is predicated in the financial stake-holding that you bear,” Reznick says. “In the US and EMs, we have seen companies we have engaged with establish science-based targets and issue sustainability-linked bonds.

“If the largest companies at the end of the value chain are responding to government calls to reduce their carbon foot- print, companies are a lot more amenable to engagement than they were because of the direction of regulatory change and increasing disclosure requirements,” he adds.

So, speaking with management as a bondholder can be just as effective as speaking with them as a shareholder. “Engagement is different in the bond market than for equities, but it does not prevent bond managers from engaging with issuers,” Amundi ETF’s Guignard says.

Allianz’s Pellegrini calls for investors to take a “humble and realistic” approach to what can be achieved in engagement. “We can push issues and make emerging market sovereigns and corporates aware that we demand explanations on certain points.

“We expect a high level of engagement with the emerging mar- ket corporates and sovereigns that we invest in,” she adds. For BNP Paribas AM’s Gordillo, engagement is just one of three areas where ESG is changing the way the asset manager works in fixed income. “We engage with pure fixed income players, but an interesting development is engaging with sovereigns. This is new in the market. We are doing it. We are learning,” Gordillo says.

The second is its role in credit analysis. “There is a movement for ESG as a tool to complement the assessment around default risk, thus enhancing the credit assessment framework.”

The third development is thematic bonds. “Last year we saw the emergence of the social bond market, in part because of the Covid response. We also see other structures, like SLBs,” Gordillo adds.

A catalyst?

The green bond market is growing, but it is still a small part of the global debt market. Another concern is that issuers tend to be concentrated in a few sectors. So, could the UK’s plan to issue a green gilt prove to be the catalyst that sparks further growth and brings new issuers to the market?

Gordillo points to the example set in Europe, which saw its first green sovereign bond issued by Poland in 2016. “That created dynamism. That helped to create a green yield curve, which is a reference point for future transactions.”

This last point regarding a green gilt is important for the development of the market. “We believe it could help support pricing by establishing a green curve that corporate green bond issuers can reference,” Nietsch says.

One market watcher believes that the UK could have work to do if it wants to grow its corporate green bond market. “In other European markets, sovereign green issuance can be a catalyst for more corporate green debt,” Lawrence says. “In the following 12 months, there is a higher volume of issuance, a greater diversification of issuers and more first-time issuers.

“However, we need to acknowledge that the EU has moved faster in terms of the regulatory framework around climate and green bonds. The UK is slightly behind on its journey,” he adds. His colleague believes that there are other positive factors at play. “Irrespective of whether the UK government issues a green gilt or not, this market is growing,” King says. “It is being pushed by investment banks. It is the shiny new toy to showcase to corporates and is a good way for those corporates to simply explain to the market how they are making their portfolios sustainable.”

Freedman points to the impact green sovereign-debt issuances in Europe have had as a source of optimism that the proposed green gilt could be a catalyst for wider corporate issuance in the UK. “The reporting framework is as important for the impact that the use of proceeds brings, because that encourages the private sector to follow suit,” Freedman says.

Setting a standard

To encourage further growth in the green debt space, the EU has introduced a system, a taxonomy, to define what a sustainable asset is. “The regulatory landscape is evolving fast,” Guignard says. “Anything that helps define standards is welcomed by asset managers and investors.

“There is a diversity of local labels or regulations and it is difficult to find a consensus between them,” he adds. “The EU’s initiative is creating standards and will help the consensus on ESG matters.”

The initiative has been welcomed in Europe. “It is an important evolution,” Reznick says. “The enhanced reporting requirements and demands on labelling will be positive in identifying the greenwashers. It will also create barriers of entry, so companies will have to strengthen their sustainability credentials to access capital.

“Having more information makes it easier for us to assess, engage and track,” he adds. The EU’s taxonomy will give clarity on what a green asset or project is. For Gordillo, this is a benefit, but he questions how the taxonomy will be used?

“We are seeing efforts from corporates which are starting to report their revenues and capex using the taxonomy. Next year there will be an obligation to report on the taxonomy. Information availability is crucial. The taxonomy will allow different market players, including central banks, to push for and sup- port more green assets.” he adds.

The taxonomy will help develop the market as access to information has been described as “patchy” by some. “It is interesting how ESG has gone from being a “wouldn’t it be nice to make the world a better place” approach to being data driven. That trend is accelerating,” King says.

“Our clients and regulators are not only asking for proof of how we assess companies, but also the engagement we do and how our portfolios look at an aggregate level. This is data-intensive work. We do a huge amount of quantitative analysis to support that and it is only going to grow.”

However, it is not perfect. “It could fuel growth in the bond market, but the taxonomy is a narrow set of criteria, so a lot of capital will be chasing a small group of issuers, which could mean that some areas of the market overheat,” Freedman says. “This goes against the bigger picture of what we are trying to do, but as the taxonomy is refined to whether oil and gas be excluded, it will encourage growth in certain areas. There will be more taxonomy-aligned issuance in time,” he adds.

More to come

Despite these concerns, the future looks bright. “In green bonds, I expect more supply and a broadening of sectors,” Freedman says. The oil and gas sector will see a major company issue its first sustainability-linked bond this year, Freedman adds, which would be a significant moment, given the industry’s role in damaging the climate.

For Reznick, focusing on his two objectives when building a bond portfolio is crucial. “At the end of the day we are fixed income investors trying to deliver into two investment objectives: a financial return and a return to the environment and society. We cannot lose sight of one or the other to deliver on those objectives,” he says.

Gordillo is also optimistic. “The thematic bond market it is about 1% of the global debt market, so there is room to grow. “Thematic bonds have succeeded in introducing the sustainability agenda to actors that never look at it – regulators and central banks. This is something that could change how the market works. “These are exciting times in fixed income,” he adds.

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