The growing recognition of climate change and environmental issues has resulted in the ‘ESG-labelled’ bond market expanding to surge through the $1trn issuance threshold for the first time last year.
This class of bond – green, social, sustainability, and sustainability-linked – was virtually non-existent as recently as 10 or 15 years ago. They provide investors a financial return as well as a positive impact on environmental or social issues.
The growth in labelled bonds means that they are now a significant part of the investment grade corporate bond market: 16% of the European market and 11% of the sterling market (in the US it is more modest at 6%).
While green bonds are still the most prominent type of labelled bond, making up almost 60% of the total market, there has been a number of innovative new products developed in recent years – with social, sustainable and sustainability-linked bonds becoming increasingly popular instruments, making up over half of the issuance last year.
Sustainability bonds, like green and social bonds, are linked to specific projects although can be allocated to a combination. The water company Severn Trent, for example, reported that its sustainable bond proceeds has been allocated: 50% on its network infrastructure; 34% on the environment; 14% on water quality; 1% on social outcomes.
Alternatively, sustainability-linked bonds aren’t project-specific, with the issuer setting specific overall targets, such as reducing carbon emissions. If they fail to achieve these outcomes then the coupon steps up as a penalty, so their borrowing costs increase.
Labelled bonds require careful analysis
While it’s encouraging to see sustainable projects attract this surge in capital, it’s sensible for investors to approach labelled bonds with a degree of caution. The capital from green or social bonds may be earmarked for a specific project, but the cash flows are not completely ringfenced from the issuer’s other operations, so investors need to be comfortable in the organisation’s overall prospects both from a sustainability and credit quality perspective.
Green bonds ultimately give you exposure to the issuer’s wider operations. Revenues from green projects will flow up to the issuer to mix in with all its other operations, while interest payments on the bonds will also be paid by the parent issuer rather than originating solely from the green project itself.
For this reason, it is essential to evaluate both the sustainability impacts and credit fundamentals at the issuer level, rather than just focusing on the bond itself.
For example, some investors avoid green bonds from oil & gas companies, reasoning that the bonds give direct exposure to the sustainability profile of the overall business. For those investors avoiding exposure to the oil & gas sector due to the need to transition away from fossil fuels, it also makes sense to avoid their green bonds.
In-depth ESG and fundamental analysis at the issuer level is vital
Effective investing in this space requires in-depth analysis of issuer-specific factors, including ESG factors and macroeconomic analysis.
For each company, key environmental, social and governance factors should be assessed as important indicators of future success. Bonds also require rigorous fundamental analysis around credit quality, macroeconomic factors and valuations to ensure they offer attractive investment returns.
Taking a thematic approach to fixed income investments
Identifying companies whose core products or services are making a positive contribution to society or the environment is one way investors may integrate sustainability into bond portfolios.
As bondholders, we need to limit downside (default) risk while maximising the returns received in the form of bond coupon and principal payments.
Reducing the small tail risk of a large loss – a bond default or negative credit event – is a key element that drives long-term returns in bond portfolios.
In practice, this can mean greater emphasis on resilience and stability than equity investors. This often translates to having less exposure to small and mid-cap companies; the investable bond universe is skewed to larger, more established companies.
Growth in labelled bonds is encouraging, but sustainable investors need to consider the bigger picture
As sustainability advocates, we welcome the wave of new capital being raised for dedicated green and social projects: every pound or dollar invested towards supporting a transition to a more sustainable economy is vital.
However, simply buying in an ESG-labelled bond doesn’t guarantee your investment is deployed sustainably. For this, investors need to conduct fundamental analysis, ensuring the bond issuer’s other operations also fit their sustainability criteria – and, of course, ensuring that credit quality and valuations also offer the potential for attractive returns.
