Increased demand for green bonds has spurred the standardisation and review process of the asset class, according to some investment specialists. However, investors are urged to proceed with caution given higher prices or ‘greenmiums’, alongside a lack of control as to how the money is ultimately spent by the issuers.
Martin Foden, head of sterling credit research at Royal London Asset Management (RLAM), said he’s a “supporter” of green bonds and other labelled bonds on a conceptual level, for bringing important societal issues to the forefront of the investment community’s consciousness but the practical application can be troublesome. Limitations in the corporate bond space means RLAM does not prioritise green bond investments, even in its sustainable portfolios.
“The majority of corporate bonds, whether labelled or not, tend to be unsecured. Once you’ve lent that money, it can go in any direction because it’s entirely fungible within the company, and you could potentially lend to a company based on some eligible investment or a particular project but lose control and visibility of that money once you invest it.
“Ultimately, we’re credit investors, and there are fundamental risks of being a creditor. It may be an extreme example, but perhaps you’re funding a fantastic green project with wonderful credentials, but they get into trouble down the line – the asset you funded might be fine, but naturally, through reorganisation or restructuring, that asset could be taken away and given to other creditors, and you could be left with the rump of a business which may not be ‘green’.”
Foden added that, as green bonds tend to be both quick and convenient they may be being used as a superficial shortcut. This leads to an increased price for the bond – a phenomenon known as a ‘greenmium’ – as issuers attempt to capitalise on the need for investors to demonstrate their green credentials to their clients.
“Immediately, your antenna starts twitching as a credit analyst – if we’re losing return, there must be some compensation for that. If those labels are simply a marketing tool without achieving any real additionality in terms of what the money is being used for then that doesn’t feel very sustainable or responsible.”
The case for green bonds
However, Rosl Veltmeijer, fund manager of Triodos Investment Manager’s Sterling Bond Impact Fund, said that what makes investing in green bonds attractive is the additional information that is provided in relation to the use of proceeds.
“This makes it easy to steer the investments in a certain direction and to measure the impact that is achieved through investing in these bonds,” surmised Veltmeijer.
“In terms of how we approach the purchase of these bonds, we always look beyond the label. Who is the issuer of the bond? Do they meet our minimum standards? And is there additionality within the projects financed? For those reasons, we don’t invest in pure refinance instruments.”
Veltmeijer also addressed the issue of greenmiums and said that they can be related to the higher demand for green bonds and/or investors valuing less risk related to them – both of which can drive the price of the bonds up.
“The greenmium typically varies between 0 and 10 basis points and also depends on the size and liquidity of the bond. A liquid green sovereign bond typically has a lower greenmium than a smaller-sized bond with a lower credit rating. What we see is that this greenmium also holds in the secondary market.”
Daniel Babington, portfolio manager at TAM Asset Management, agreed. He said that green bonds “have proved a fantastic way to finance decarbonisation projects” and push companies towards their goals. Given this, TAM utilises use-of-proceeds bonds within their sustainable world portfolios in conjunction with non-labelled strategies.
“We find the labelled strategies, particularly when invested into at issuance, provide that additionality which is a crucial component of impact investing, as it is providing new capital. At a high level, the ringfencing for positive environmental and social outcomes provides materiality while the decision to issue labelled bonds shows positive intentionality.”
For Babington, the critical component is employing active fund managers with a valuation-conscious approach and an understanding of whether the impact case of the issuance aligns with the need to deliver a strong risk/reward ratio, including the presence of a greenmium.
“If use of proceeds bonds, such as green bonds, are collated and built on by a high-quality fund manager who introduces key performance indicators and engages for better outcomes with the company, then we see a strong sustainability strategy.”
Green bond standards
Babington also noted that strong demand for green bonds is also spurring efforts globally to standardise the creation and reviewing of them. Last November, for example, the European Union published its European Green Bonds Regulation, which introduced the European Green Bond Standard (EuGBS), a designation which can be used voluntarily by bond issuers to provide greater confidence in the market.
To use the designation of ‘European Green Bond’, issuers must satisfy certain requirements concerning the use of proceeds, reporting and disclosure. This includes the need for proceeds to be fully invested in environmentally sustainable economic activities, meet disclosure requirements under the Prospectus Regulation and produce an impact report post-issuance.
According to analysis by White & Case, applying the Taxonomy Regulation in practice and issuing in accordance with the other requirements in the EuGBS “may present challenges” for some issuers, with most having gaps between their existing internal data collection and the data requirements of the regulation. Increased documentation, monitoring and time will be necessary to complete and monitor the use of proceeds.
Foden also added that many of the third-party providers of ESG information originate in the equity market, meaning that, when looking at fixed income – where a large number of bonds won’t have equity-listed parents – there’s a fairly significant coverage gap. This places a further onus on fund managers to undertake their own credit analysis.
Nevertheless, as green bond standards develop around the world, Babington argued that issuers “will have increased confidence in the alignment credentials of the bonds” and would no longer have to rely solely on voluntary standards. This “will be a likely boon to the green bond market”, he said, as standardisation increases both transparency and trust for investors.
“Appetite to issue will likely continue to increase as sustainability becomes an increasing part of issuer’s corporate strategies. This will likely be met with increased demand due to the longer-term structural move towards ESG integration across asset management in asset allocation decisions.”
‘There’s no shortcut’ to incorporating ESG
In the meantime, while there is a clear data issue that “anchors investors to the most efficient parts of the market”, RLAM would “continue to operate in the nooks and crannies” to find the points at which they can add value, turning information challenges into opportunities, concluded Foden.
One example he gave was an investment in Bazalgette Finance, a company currently financing the construction of the Thames Tideway ‘super sewer’. While a superficial assessment would cast the sustainability of the investment into doubt – thanks in large part to high embedded carbon emissions – Foden said that collaboration between RLAM’s fixed-income credit experts and responsible investment experts identified the opportunity because of the broader environmental and social benefits the structure would bring over the long term. Such granularity and specific knowledge is an essential part of the investment process.
“There is no shortcut to this. Convenience comes at a cost – we have to understand the idiosyncrasies of bond issuers and ensure we do our due diligence from the bottom up. That’s not to say that we won’t invest in labelled bonds or use third-party data. But it can only ever be a supplement to what we do, rather than all of what we do. If people are finding the integration of ESG easy, then they’re probably not doing it correctly.”
