Transparency with sustainable corporate bonds
Corporate bond spreads have narrowed sharply. Nonetheless, the market is still interesting to investors because the rapid growth of sustainable corporate bonds is creating new investment opportunities.
The market for sustainable corporate bonds is seeing rapid growth, but supply is still outweighed by investor demand. This is partly due to regulatory reasons and partly to the opportunities for further diversifying investment portfolios. Although the market for sustainable bonds does not yet offer the same diversity as the traditional corporate bond market, it does cater to many different tastes. For example, investors can put their money into sustainable senior secured bonds, sustainable senior preferred and non-preferred bonds in the financial sector, and subordinated bonds. Moreover, the market now covers many currency areas, and it is possible to climb the risk ladder by investing in the high-yield segment.
The breakthrough for sustainable corporate bonds came on 20 November 2013 in the shape of a green bond from French utility company EDF (Électricité de France). This example illustrates the differences in how each country interprets the terms ‘green’ and ‘sustainable’. EDF is heavily involved in nuclear energy, which means that its bonds cannot be included in sustainability-oriented mutual funds as far as Union Investment is concerned. Aside from the question of the sustainability of nuclear waste, there is also a business reason for not including them: A company’s green bond is jointly and severally liable. The investors in the company’s green bond would therefore also be required to pay up in the event of a disaster at a nuclear power station and a resulting deterioration in credit quality.
Growing demand for sustainable bonds
Rapid expansion of market for sustainable bonds
New issues mainly denominated in euros
Ring-fenced projects and increased transparency
Since then, green bonds have proved to be a rapidly expanding market segment. Just a few years later, they were joined by social bonds and sustainability bonds. The latter two groups make up a growing share of the volume of sustainable bonds issued, but are mainly issued by quasi-governmental institutions (such as development banks) and rarely by companies. What is common to all three types is that the proceeds raised have to be ring-fenced for specific projects for which the company has to account. These can be clearly definable sustainability projects, such as investment in generating electricity from renewable sources in order to lower the company’s own greenhouse gas emissions or improvements to the environmental footprint of the company’s manufacturing processes or supply chains.
This is not the case for a bond type first seen in 2019, the sustainability-linked bond (SLB). Companies use these bonds to invest in projects that help them to reach company-wide sustainability performance targets and for which certain key performance indicators (KPIs) have to be achieved. If these KPIs are not achieved within the period of time defined at the time of issue, the company is ‘punished’ for its failings by having to pay a higher coupon rate (step-up) to investors (see the chart). Progress with achievement of the KPIs is audited regularly by an external auditor.
These different bonds create interesting investment opportunities. The proceeds from sustainable bonds do not just end up in a general pot that the company can use as it wishes. Instead, the money invested in green, social and sustainability bonds has to be used for a specific, relevant purpose. Although the money put into sustainability-linked bonds can be used for the company’s general purposes, it is linked to sustainability targets. In the case of green, social and sustainability bonds, investors are also buying transparency with regard to the use of proceeds because the issuance of such bonds is linked to specific conditions. For SLBs, transparency is bought in the form of the company’s sustainable business activities. By issuing the bonds, the issuers undertake to account regularly for how they are using the proceeds received and, for example, the extent to which they have reduced their carbon emissions.
Classification of sustainable themed bonds
Sustained high demand
Strong demand for such bonds has led to the establishment of a price mark-up for green government bonds in the market. In other words, investors are paying a premium for green bonds – a ‘greenium’ – compared with conventional bonds. Germany’s green government bonds, for example, are trading higher than equivalent conventional Bunds. Union Investment does not believe that the greenium will disappear any time soon. The growing, albeit limited, supply of green bonds and unfaltering strong demand for sustainable paper are not expected to reach equilibrium quickly. Furthermore, the European Central Bank (ECB), for example, wants to place greater emphasis on sustainability in its bond buying. This is likely to exacerbate the imbalance to the detriment of sustainability-oriented investors.
Transformation with sustainability-linked bonds
For investors with an appetite for risk, it may be worth taking a look at sustainability-linked bonds. In the market for sustainable bonds, a disproportionately high number of SLBs are high-yield and offered by issuers from emerging markets or Europe. SLBs are particularly useful to small and medium-sized enterprises that are not yet very sustainable – i.e. ‘brown’ companies – as a way of obtaining funding for their green transformation. It is essential to carefully evaluate the company and the credibility of the transformation expressed with the SLB. Given their size, most SLB issuers tend to have less scope to specifically offer individual sustainable projects for funding, e.g. with a green bond. Moreover, they often do not have the resources required to carry out standardised issues for individual projects. One of the criticisms of SLBs, however, is that the basis is not standardised. For example, targets for reducing greenhouse gases are calculated with different baseline years. It naturally makes a difference whether a target for greenhouse gas emissions is calculated in reference to the volume in 2011 or 2013.
Despite such criticism, the SLB market has seen a rapid uplift thanks to the definition of the SLB standard by the International Capital Market Association (ICMA) in 2020 and the inclusion of SLBs in the ECB’s list of assets eligible as collateral in September of that year. Union Investment therefore anticipates continued strong growth. “There is nothing to stop all companies issuing their bonds as SLBs in the long term and it is not really clear why conventional bonds are still being issued,” says Michael Kobel, a fund manager at Union Investment. “After all, every company that sets a climate target for itself can actually classify any use of the proceeds as contributing to this target.”
Industry heavyweight Deutsche Telekom, for example, has now also created a framework for the issuance of SLBs. Union Investment is actively engaging with companies to encourage them to issue sustainable bonds in greater number in order to finance and push ahead with their green transformation. This calls for active security selection in order to meet predefined sustainability criteria. Where SLBs are purchased as part of sustainability-oriented products, ESG filters are applied because there is significant variation in the quality of the issuers from an ESG perspective. Close monitoring of the companies and thorough analysis of the performance reports are also required in order to ensure that the intended transformation effects are achieved.
Moreover, active security selection can take the differences between the valuations of sustainable bonds into consideration. For example, bonds with a high ESG score (i.e. an above-average sustainability rating) are valued more highly than conventional bonds at present. However, this is not yet the case with regard to carbon emissions. This shows that optimum investment performance cannot be expected by applying simple exclusion lists alone. “A forward-looking approach is required, i.e. where will companies that currently have a demonstrably poor carbon emissions performance be in five years’ time,” says Kobel. It is important that this is carried out carefully and in line with the customer’s wishes and restrictions.
As at 12 November 2021.