How to test which bonds are truly sustainable

AB portfolio managers say investors must use a disciplined framework to evaluate the flurry of new ESG bonds


Tiffanie Wong, director of fixed income responsible investing and Salima Lamdouar, portfolio manager AB Sustainable Fixed Income, AllianceBernstein

More securities labeled as ESG bonds are being issued by a wider variety of companies than ever before. This is a welcome development, because such financing will play a critical role in the global transition to a greener world. But not all ESG-labeled bonds are equal. To fund a genuinely green future, investors will need to separate the wheat from the chaff.

ESG-labeled bond issuance surged to new heights in 2021. Though Europe remained the leader, new regions rapidly adopted these financing structures. Green bonds, which fund particular projects, continued to dominate. But issuance of social, sustainability and sustainability-linked bonds—which reference specific key performance indicators, or KPIs—grew fastest.

See also:- Fixed income chapter of the 2021-2022 ESG Annual

The range of issuers has broadened as well. Until recently, ESG bond issuance was mainly the preserve of investment-grade issuers. But in 2021, high-yield issuance across US dollar and euro markets quadrupled. What’s more, many industries featured in the list of ESG bond issuers for the first time: in euro markets, chemicals, consumer products, and metals and mining; and in the US, autos, chemical and telecoms. The use of proceeds and range of projects widened too.

As new ESG-linked issues proliferate, it’s critical investors use a disciplined framework to evaluate them. Bonds whose terms merely gesture towards environmental and social factors but have no real impact are less likely to perform well over the long term, making a bond’s design as important as its price. 

What to look out for

The first test bond investors must apply is materiality. Does the KPI target for a sustainability-linked bond represent a material improvement for the entire firm? Is the use of proceeds for a green bond significant to the issuer’s business and industry? We’ve noted instances where KPIs or use of proceeds covered only tiny parts of a company. By contrast, Faurecia’s Green Notes issue was fully aligned with the firm’s core mission of sustainable mobility, and its use of proceeds supports the company’s ambition to diversify into hydrogen-powered transport.

Issuers should also provide a green bond framework or corporate plan, together with basic firmwide commitments, such as adopting a transition pathway in line with 1.5 degrees warming or aiming for net-zero carbon output on most relevant scopes (for most industries, that includes scope 3). Certain sectors, such as automakers and utilities, have their own specific climate undertakings—for example, a timeline for transitioning to all-electric vehicles.

On the social side, look for policies that mitigate modern slavery risk. Sustainability-linked structures that lack ambitious objectives are generally unattractive. Some KPI targets are overly generic and disappointingly modest. In these cases, investors need to press for specific goals and stretch KPIs, such as Henkel’s, whose KPIs are specific, set readily measurable goals across the whole business, include scope 3 emissions and feature some timelines as short as five years. Industry peer comparisons can help determine whether an issue’s terms can be benchmarked to best practices and whether KPIs are sufficiently demanding.

It’s also important to consider both the timeline of the KPIs and the penalty for non-performance. Issuers that fail to hit their KPI targets must typically pay an increased coupon to defray potential bond price losses from the negative ESG outcome. But investors need to scrutinise whether the coupon step-up adequately compensates for the miss, and whether they will receive enough enhanced coupon payments before the KPI timeline expires. Too many structures currently feature limited step-ups with back-ended penalties. If investors want a genuinely green future, they must push back against easy structures and limited repercussions.

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