Growing Green: The Rise of Green and Sustainable Corporate Bonds
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2020 saw an increase in the volume of green and sustainable-linked bonds being issued and in the breadth of industries issuing these bonds: a growth trend set to continue into 2021. Against this backdrop, the assessment of eligible project credentials and the feasibility of sustainability targets – ensuring bonds deliver meaningful improvement and are not merely a tool for greenwashing – is valuable when deciding where to invest.
Investor interest in sustainability and ESG (Environmental, Social and Governance) factors has increased significantly over the last few years and most notably in 2020. The fixed income market is no exception and the green/sustainability-linked bond market has also seen dramatic growth. As regulatory pressures intensify, we expect the market to continue to grow in importance and diversification as companies across more sectors start to issue green and sustainability-linked bonds.
Green bonds are issued by corporates and governments to finance projects that meet a specific set of environmentally friendly criteria. This could include, for example, investment in a renewable energy project or an efficiency upgrade of a company’s headquarters. Sustainability-linked bonds are slightly different, with financial penalties (usually in the form of a coupon step-up) if a company fails to meet a set of ESG targets such as % emissions reduction by 2025 or % employee satisfaction, for example.
Where is issuance coming from?
The green and sustainable corporate bond market has risen in size from below £70bn of debt outstanding in 2014 to above £600bn in 2020. Approximately £140bn of green or sustainable corporate bonds were issued in 2020 globally, 12.5% more than 2019. The largest corporate green issuers in 2020 remained within the utilities sector, but companies in the real estate, industrial and auto sectors have also begun issuing large sums. Euro remains the largest green and sustainable bond currency, but the US dollar is rapidly catching up. Forecasts vary, but we expect another £140-£160bn of green and sustainable corporate bond issuance in 2021.
Corporate Green, Social and Sustainability Bonds Issued, £ bn
Source: BMO Global Asset Management, Bloomberg, as at 31 December 2020
As well as an increase in volume, 2020 saw an increase in the breadth of industries issuing green and sustainable bonds which will likely continue into 2021 and beyond. Sustainability-linked bonds are often more accessible to many companies looking to issue ESG-friendly bonds, who would otherwise be ineligible to issue green-bonds. This is particularly the case in sectors that have great difficulty in abating emissions, such as companies in the industrial sector. In 2018, sustainability-linked debt made up 10% of green and sustainable issuance. This rose to 28% in 2020 and is likely to only increase further.
A holistic investment approach: how green is green?
While green and sustainable bonds do allow companies to express their ESG intentions, they also often mean cheaper funding costs for the company versus regular bonds, given the scale of demand versus supply within the ESG space. This increases the importance of questions about greenwashing, the impact of these ESG-linked bonds on a company’s debt structure, the green-premium (how much more expensive it is for investors to buy green or sustainable bonds than regular bonds) and its durability.
This is particularly the case in sectors that have a less established green and sustainable bond market in terms of scale and depth of issuance, and consequently where there is a high demand for ESG bonds. Earlier this year, for example, Daimler and VW issued inaugural green bonds that were more expensive to buy (0.20-25% lower in yield) than non-green equivalents. In contrast, the utilities sector has the largest and most established green bond market and companies here, Engie for example, see little difference between the valuation of green and non-green bonds. This is illustrated in the chart below, which shows the difference in credit spread (yield above a government bond of the same maturity) between green bonds issued by Daimler and Engie versus their non-green equivalents. The wider gap between the two Daimler bonds indicates a greater divergence in the price of its green and non-green bonds.
Green vs non-green relative value
Source: BMO Global Asset Management, Bloomberg, as at 18 January 2021. Credit spreads shown from date of issue of relevant green bond. A lower credit spread equates to a higher price (i.e. the bond is more expensive).
Assessing the credentials of eligible green projects and the feasibility and meaningfulness of ESG targets, as well as corresponding penalties, is hence valuable when deciding to invest in these instruments. It is also key in deciding whether to favour a green or sustainable bond over the rest of a company’s debt structure, particularly while there is a green-premium. Will such bonds have a meaningful positive impact to a company’s sustainability goals or could they be a tool of greenwashing? Is the company receiving cheaper funding for unsubstantiated or misleading ESG claims?
In answering these questions, our Responsible Investment (RI) team plays an important role both in assessing the merits of green projects and in considering the likelihood of companies reaching sustainability targets and whether the targets themselves are meaningful. Furthermore, if the RI team consider green projects and sustainability targets as positive and meaningful, it is also important for the credit research team to consider the impact upon the rest of the business and hence the rest of the capital structure. For example, if a company has a meaningful CO2 emissions reduction target that will benefit the overall business and all bonds equally, is it more valuable for the investor purchase the non-green bonds instead of the green bonds, which are more expensive simply owing to being labelled as green?
The intentions of the European Central Bank (ECB) are also an important factor in determining value, as this may play a central role in corporates’ decisions about which type of bond to issue, as well as potentially providing technical support to the ESG-targeted market. For example, we need to consider whether purchase programs of the ECB will include: the bonds of energy companies such as Equinor, Total and BP; only the sustainable or green bonds of energy companies, or; no debt of energy companies. If the ECB decides upon the second option, this could lead to a division of debt from these companies with newly issued bonds being ESG-targeted and old bonds remaining without ESG objectives, with potentially significant differences in returns.
What’s next?
We will continue to watch the development of the green and sustainable bond market and monitor the differing performance of ESG-friendly bonds versus their non-green counterparts. Assessing the credibility of targets, projects and management intentions is extremely important in the investment decision, rather than accepting a bond as green or sustainable solely because of its label. The combination of an expert view from the RI team combined with the credit analyst’s assessment is key to making a genuine ESG impact and assessing the long-term impact upon a company’s credit quality owing to its exposure to ESG-related issues. This enables us to add value across all portfolios, not only those dedicated to ESG-focussed investment strategies.
Disclosures
This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.
Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.
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