The following article examines the fast-growing world of sustainable bonds, and how investors should address these assets. The insights come from Aviva Investors.

The following article on this topic is by Steve Waygood, chief responsible investment officer, Aviva Investors.

Link to the live article for reference: Sustainable bonds: Everybody wants one - Aviva Investors

The first smartphones had few apps, wi-fi connections were patchy and data costs prohibitive. Despite these drawbacks, smartphones are now ubiquitous. The universe of sustainable bonds is developing in a similar way. After years where only green bonds were on offer, recent years have seen demand and supply surge.

According to data provider Refinitiv, issuance of sustainable bonds totalled a record $544.3 billion in 2020, more than double the previous year. While green bond issuance of $222.6 billion was also a record, an entire new ecosystem has emerged, including social, sustainability, sustainability-linked and climate transition bonds.

The market is growing for several reasons. The first, and most powerful, driver is the recent crop of regulation by big companies and national and supranational entities setting net-zero emissions targets, such as the European Union’s (EU) Sustainable Finance Action Plan, aiming to support the transition towards sustainability after COVID-19 (1) .

Companies are also keen to tap into the surge in demand. “Firms are realising this is an opportunity to obtain financing to achieve any of their broader strategic goals, and we are seeing growth in all parts of the market,” explains Richard Butters, ESG analyst at Aviva Investors.

Illustrating the point, $164 billion of social bonds were issued in 2020 – ten times higher than 2019’s total – while the $127.6 billion of sustainability bonds were more than triple that seen in 2019. In comparison, because the sustainability-linked bond principles were only published in June 2020, just four companies had issued under the framework as of September 2020: Enel, Suzano, Novartis and Chanel.

Figure 1: ESG bond issuance 2013-2020 ($ billion)

Source: Bloomberg, Morgan Stanley Research, as of  8 January 2021

Issuers come from an increasingly diverse set of industries, after years of being concentrated in the financial, real estate, utility and renewable energy sectors. In 2020, they included automobile companies, consumer and luxury goods firms and mobile phone operators (2).

However, investors must take care to read the small print when deciding whether a sustainable bond meets their criteria. Firstly, are some sustainable bonds better than others? Secondly, if a label cannot provide enough of a guarantee against greenwashing, how can investors ensure that their allocations make a difference?

1.    What bond?
The International Capital Market Association (ICMA) has created four sets of principles that provide a framework for sustainable bonds: the Green Bond Principles (GBP), Social Bond Principles (SBP), Sustainability Bond Guidelines (SBG) and the Sustainability-Linked Bond Principles (SLBP), as well as the “Climate Transition Finance Handbook 2020” (3).  

ICMA-recognised green, social and sustainability bonds each have four components – use of proceeds, project evaluation and selection, management of proceeds, and reporting – to be verified through independent external reviews (4).

Sustainability-linked bonds (SLBs) aim to increase the development role that debt markets play in funding and encouraging sustainability. Compared with the first three types, they are more forward-looking (5).

The ICMA also states: “There is a market of sustainability themed bonds, including those linked to the Sustainable Development Goals (“SDGs”), in some cases issued by organisations that are mainly or entirely involved in sustainable activities, but their bonds are not aligned to the four core components of the Principles” (6).

Outside the ICMA ecosystem, the Climate Bonds Initiative (CBI) provides a “Climate Bonds Standard” certification of bonds and loans as being either green or aligned to the targets set out in the Paris Agreement.

2.    Decisions, Decisions
This wide variety of conventions can be confusing; investors need to be aware of the source of the “green” or “sustainable” labelling, then analyse the criteria and decide whether these meet their investment guidelines.

Within the ICMA taxonomy, green bonds have been around the longest but, as the transition accelerates, they appear to be limited in scope. Proceeds have not always been used to “dark green” ends, and this has been traditionally difficult to monitor. As an example, in 2017, Repsol issued a green bond with the proceeds intended to improve the efficiency of oil refineries (7, 8). 

As a result of such controversies, green bonds have tended to be the near-exclusive purview of already green or sustainable companies, limiting the options for more carbon-intensive firms to finance their transition efforts. For investors, this also creates concentration risk.

In addition, many ‘use of proceeds’ bonds fund prior investments. While this demonstrates an issuer’s ability to use proceeds responsibly, it raises questions as to how much of the funding should be retrospective.

As the transition began to accelerate, markets needed new types of bonds that could embrace the transformation efforts of the corporate world more effectively. Enter SLBs and climate transition bonds.

“I love sustainability-linked bonds, which are linked to a company’s whole business. A structure where companies release whole-business KPIs and then issue bonds attached to those is brilliant,” says Tom Chinery, investment-grade credit portfolio manager at Aviva Investors.

In addition, because they allow financing beyond allocating proceeds to specific projects, it gives investors an opportunity to support meaningful efforts from a wider variety of companies.

“Some of the worst companies that have ambitious targets will make far more difference to the environment than a clean company that commits to shaving off 0.1 grams of carbon emissions a year. This is why I like the Enel approach: it is talking about massive global reductions in carbon emissions (8). That is meaningful,” explains Chinery.

There are live debates about the best way to implement SLBs’ impact framework and whether there is a need for specific climate transition bonds when so many other categories already exist. But whether through a green bond, conventional bond or SLBs, the key for investors is to understand what is happening at a company level and whether the proceeds will help it become more sustainable.

3.    Influence and engagement
Sustainable bonds have two limitations. First, even the greenest bond does not necessarily mean that its issuer is becoming more sustainable (10).

Of course, fundamental analysis on companies can be resource intensive; for investors with smaller teams, buying green bonds may seem like an easy way of participating in the transition. However, the impact can be limited, as green bond projects do not necessarily translate into comparatively low or falling emissions at the firm level (11).

In addition, investors need diversification to mitigate risk, and cannot allocate solely to green sectors.

“Historically, when investing in green bonds, it has been a struggle to achieve sector and name diversification, making it more difficult to run traditional risk mitigation and portfolio construction,” says Chinery.

This is where engagement makes a difference, improving company disclosure on key metrics, which in turn allows investors to engage more effectively. And, as disclosure improves, smaller investors with fewer resources can also benefit.

There is a misconception that credit investors lack influence because they don’t have voting rights. That is not the case, particularly when they join forces, whether through industry bodies like ICMA, or internally, across credit and equity teams.

“When we engage at the issuer level, it can often set a precedent for cross-business activities. But the rise of sustainable debt also provides a new gateway for our voice to be heard, provided we engage with issuers to highlight any concerns of green or social-washing we might have when they use one of the sustainable bond frameworks,” says Butters.
 

4.    No fad
One other aspect investors and issuers will follow keenly is the cost of sustainable bond issuance versus conventional bonds.

It is too early to draw conclusions, but interesting insights emerge. The yield on Volkswagen’s 2028 green bond, for example, is lower than its conventional bond of similar maturity (0.5 per cent versus 0.42 per cent as of 9 February 2020). This may reflect the relative familiarity of European investors with sustainable bonds – the region accounted for over half of global issuance in 2020.

Meanwhile, in the US, the yields on Citigroup’s 2024 social bonds (0.61 per cent) and green bonds (0.86 per cent) are higher than its conventional bonds (0.53 per cent). Perhaps that is reflective of the US being behind Europe when it comes to sustainability, although who is to say that those spreads won’t narrow quickly as the market evolves?

What we can say with more certainty is that there is serious momentum behind the sustainable bond market globally.

On 9 February, Total committed to issuing all new bonds through sustainability-linked debt – the first company to do so (12).  Although investors will have to watch out for greenwashing, if enough issuers follow in Total’s footsteps, it could be game changing.

“The more investors focus on ESG, the more the bad operators will see their borrowing costs rise,” says Chinery. “We are not at a point now where there is that level of dispersion, but it is the direction of travel.”

Note
For the purposes of this article, we refer to the universe encompassing green, social, sustainability, sustainability-linked and climate transition bonds as "sustainable bonds."

References

1.    ‘Renewed sustainable finance strategy and implementation of the action plan on financing sustainable growth’, European Commission, 2021
2.    ‘Tracking the environmental footprints of corporate green bond issuers,’ Scope Group, 1 February 2021
3.    ‘Green Bond Principles (GBP)’, International Capital Market Association, 2021
4.    ‘Sustainable finance’, International Capital Market Association, 2021
5.    ‘Sustainability-Linked Bond Principles (SLBP)’, International Capital Market Association, 2021
6.    ‘Sustainability Bond Guidelines (SBG)’, International Capital Market Association, 2021
7.    Sophie Robinson-Tillet, ‘Analysis: Investors divided by green bond from Spanish oil company Repsol’, Responsible Investor, 11 May 2017
8.    ‘Our approach: Research-based, independent and relevant’, CICERO Shades of Green, 2021
9.    ‘Sustainability-Linked Bonds’, Enel Group, 2021

10.    Neil Unmack, ‘Breakingviews - Green bonds could slide into irrelevance’, Reuters, 17 September 2020
11.    Torsten Ehlers, Benoit Mojon and Frank Packer, ‘Green bonds and carbon emissions: exploring the case for a rating system at the firm level’, BIS, 14 September 2020
12.    Francois de Beaupuy and Priscila Azevedo Rocha, ‘Total to sell only ESG-linked bonds in first for debt market,, Bloomberg Law, 9 February 2021

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