Since we first discussed ethical investing in the fixed income space, the sector has continued to grow and develop, with demand for ethical social and governance (ESG) bonds widening beyond ‘niche’ investors. Here we look at the developments in the space and what to expect from ethical investing going forward.
Background
The term ESG bonds refers to a type of debt instrument where an issuer has identified certain environmental, social, or governance criteria for the use of the bond proceeds.
Global issuance of ESG bonds hit $1 trillion for the first time last year according to Bloomberg, which was more than double sold in 2020. It’s a sector that’s set for continued exponential growth and one to keep an eye on this year.
Where previously it was viewed for those with a sustainable or socially responsible investment approach, as the wider public conscience changes and more issuance comes to market, it’s now considered more mainstream and a compelling investment choice.
With more ESG bonds being issued, the additional supply improves the demand imbalance and in turn there is more available for a wider investor base and at improved pricing, making returns more attractive.
Developments & trends
As the segment continues to grow, so too do the types of ESG bonds on offer and the different aspects, from ‘greenwashing’ to ‘greenium’.
Last year we saw an increase in the number of ‘Sustainability-linked’ bonds issued, the newest addition to the ESG fixed income space (first issued in 2019). This type of bond is where the proceeds aren’t ring-fenced for a specific green project (as is the case for a green bond), however there are sustainability performance targets that must be met, and the interest rate on the bond is adjusted accordingly.
If the issuer meets its sustainability performance targets during the term of the bond, then its interest rate will decrease, and likewise if it misses, its interest rate will increase. These types of bonds widen the access to sustainable markets for more issuers, who otherwise wouldn’t be considered ESG.
Without a global standard classification on ESG bonds, and issuers clambering to secure a piece of this growing market, there is concern around ‘greenwashing’. This is where issuance may be labelled as ESG, where is may not be the case. It is also referred to as ‘green sheen’.
An example is where an issuer places a new green bond, as it meets an internal sustainable framework, however, all the while having no zero-emissions target or being a known large global polluter.
However, with the ESG market continuing to grow, there is progress towards a global standard to classify bonds. The level of transparency and ESG reporting demanded by investors is helping this, along with the likes of Bloomberg, Sustainalytics and MSCI, who have their own transparent classification measures.
As investor demand outstrips issuer supply currently, a premium exists on ESG bonds, in particular green bonds. This is referred to as the ‘greenium’ (green premium), which is where an investor is willing to accept a lower yield on a green bond in comparison to a conventional issue.
This also creates an incentive for issuers to raise green debt, where they can do so at a lower cost. The below chart illustrates the tighter spread on a green issue compared to a non-ESG issue.
However, as the number of issuers and issuance alike grow in the ESG space, this spread differential will compress, making ethical investing an even more attractive option from a return perspective.
Green issuance is eclipsing governance and social issues at the top of the ESG agenda, reflecting the growing awareness of climate issues such as rising global temperatures and erratic weather events, including fires and floods.
Sovereigns and supranationals have begun to outpace corporate issuers in size of green-bond issuance according to the MSCI ESG 2021 Report. These includes climate-change-adaption projects, which assist with adapting to a changing climate and include flood mitigation and improvements to climate-modelling.
The growth in green bonds is also evident in the Australian fixed income market, with $6.8bn issued over 2021, which is almost three times the amount issued last year. As regulation and classification around what is considered to be a green bond standardises, along with increasing investor demand for these types of investment options, its growth is set to continue.
Conclusion
As ethical investing continues to gain pace in the fixed income space, investors are including a larger ESG allocation to their bond portfolios.
Of the $6.8bn bonds issued in the Australian market last year, FIIG secured allocations for clients in the primary market and actively trade most in secondary. These include the $300m green issuance from Lendlease, and the dual-tranche sustainability-linked bond offering from Woolworths, where $700m was raised from a staggering $1.6bn order book.
If you’d like to find out more on how ESG bonds can add an ethical element to your non-bond portfolio, please reach out to your FIIG contact.