Rapidly growing market for bonds with an impact
Investor awareness of sustainability has grown exponentially in the past five years. The major rating agencies have taken note of this development and are satisfying the need for more in-depth insight by appraising issuers according to environmental, social and governance (ESG) criteria. With that information in hand, many investors also stipulate specific exclusionary criteria. Depending on the degree to which these factors are accounted for in the portfolio, its structure need not differ significantly from the way it was before.
For some investors, this process may be sufficient – but perhaps not for others who are resolutely focused on sustainability yet want their investments to generate concrete, measurable and sustainable benefits to society and the environment. The aim of these investors is to bring about change at companies. This is a difficult quest in the stock markets since companies normally do not pursue just one sustainability objective. But the situation is different when it comes to the issuers of fixed-income securities. In this area, a steadily growing array of new solutions is being designed explicitly to fund and realise sustainable projects. In the following, we introduce you to this universe and describe how green, social and sustainability bonds work.
“ESG” versus “impact”
Bond prospectuses not only address matters such as collateral and seniority ranking, but also the intended use of the proceeds. The latter, a clearly defined purpose clause, represents the heart of impact bonds, as it specifies that the money raised from such issues will be used solely for the funding of sustainable projects.
Depending on the nature of the various projects, different market segments with their own designation have emerged, for instance “green bonds” that are devoted to renewable energy sources. Most issuers of these bonds voluntarily adhere to the governance and reporting practices prescribed by bodies such as the International Capital Markets Association (ICMA). Nonetheless, investors need to ascertain whether the project objective(s) described in the offering prospectus are in line with their personal investment philosophy.
From an investor’s point of view, the question naturally arises as to what would have happened without their investment? Would a company with an otherwise good ESG rating have acted in the same way after issuing a traditional bond as opposed to an impact bond? The so-called “additionality principle” applies here: impact investments not only effect something; they also provide the impetus for it. It follows that impact investors provide the fuel for sustainable change.
Yield still plays a role
The returns that can be expected from impact bonds range from the going market yield on traditional bonds, to what in effect is roughly equivalent to an asset-diminishing donation. So it should come as no surprise that investments made with a financial goal in mind, but which at the same time take environmental, social and governance (ESG) criteria into account, are particularly popular among investors.
Earning a reasonable yield and “doing good” are not necessarily mutually exclusive aspirations. However, the more intently an investor focuses on the actual impact (i.e. the goal), the more the related investment takes on the character of financial aid or even a charitable donation. It follows that the blended approach – i.e. making an impact without sacrificing yield – is currently the primary driver of growth in this market.
Categorisation of ESG/impact bonds
Market segments and market volumes
The market segments for impact bonds differ not only in terms of the anticipated yields, but also according to the purpose for which the funding is to be used (see chart below). Very popular today are bonds that deploy the proceeds in a way that achieves environmental goals. Relatively new and less well known are issues that are focused on social challenges. For example, since the Covid outbreak, pandemic bonds have come into being as a means of countering the economic consequences of the pandemic.
Sustainability bonds, on the other hand, are a hybrid form of a debt instrument that pursue green and social objectives. There have also been bonds with predefined sustainability targets: if a target is not reached, the issuer pays a higher coupon as a kind of penalty. However, with these sustainability-linked bonds, the intended use of the funds is not specified in advance.
Green bonds constitute the most firmly established “impact” segment. Here, the proceeds are used to finance climate protection or environmental projects such as renewable energy or charging stations for electric vehicles. This year alone, green bonds with a cumulative value of almost USD 500 billion have been issued, and 89% of the respective ratings are in the investment grade range. The largest issuers are European countries and their supranational institutions such as the Kreditanstalt für Wiederaufbau (KfW), European Investment Bank (EIB) or the EU itself. Accordingly, the market for euro-denominated green bonds is the largest with a 51% share, followed by USD bonds at 21% and 8% for those denominated in CNY.
Issuers from the emerging nations occasionally tap the market – China is the dominate player in this regard. However, EM and high-yield green bonds tend to be the exception. As a result, the yields are roughly in line with the creditworthiness of the given issuer, which usually corresponds to that of European government paper. No significant premium or discount is priced in for the green factor. At the sector-specific level, sovereign and quasi-sovereign debt, financials and utilities account for 86% of the outstanding volume.
In effort to prevent greenwashing, i.e. issuers’ hyped or even fallacious pretention to greenness, the ICMA has developed clear requirements: the so-called Green Bond Principles (link) set forth guidelines on transparency, disclosure and reporting. Fuelled by the EU Green Deal, China’s commitment to carbon neutrality by 2060, and America’s Build Back Better plan, the green market is expected to continue its strong growth. Moreover, central banks across the globe are becoming increasingly involved in climate change. Transparency requirements in the form of new regulations and the introduction of defined classifications (taxonomy) should help to ensure that more money from investors and financial institutions flows into green bonds.
At present there are roughly 4100 individual issues of green bonds available on the market, representing a total volume of USD 1.272 trillion. The minimum denomination of these bonds is usually at least EUR 50,000.
Development of green bonds
Blue and brown bonds
Blue bonds are a very young subcategory of green bonds. The first issue in this niche was launched by the Seychelles in 2018, with the provision that the proceeds be used to finance projects involved in marine conservation, e.g. the management of plastic waste, but also the promotion of marine biodiversity through sustainable, clean and environmentally friendly undertakings. At present, only a few bond issues of this kind are available and thus it is not yet feasible to take the targeted investment fund approach.
In the case of brown bonds, the issue proceeds are aimed at enabling carbon-intensive industries to transition to a greener future. The funding is typically directed towards renewable energy, green hydrogen, or Carbon Capture Utilisation & Storage (CCUS) projects. The relevant details are set out in ICMA’s Climate Transition Finance Handbook, with the objective of accelerating investments in a carbon-neutral tomorrow. Here as well, the market is still small: in 2020 there were only four offerings from three issuers, namely Cadent Gas, Etihad Airways and Italy’s natural gas transmission operator Snam. Currently, 9 brown bonds with a volume of USD 4 billion are available.
The proceeds from social bond issues are deployed in projects that have a clearly positive social impact, such as access to education, affordable housing or improving food safety. The ICMA's Social Bond Principles (link) specify that projects deemed to be of a social nature can also include health and medical research relating to COVID-19, as well as vaccine development and investments in medical equipment. For this reason, the market volume surged in 2020 and has continued to grow. Guatemala was the first country to issue pandemic bonds as a way of financing measures to combat the coronavirus.
Compared to green bonds, where the quantitative improvements are relatively easy to track, the challenge with social bonds comes from the fact that their accomplishments are more qualitative than quantifiable. The ICMA Principles are of greater importance here, as they seek to prevent the occurrence of “social washing”, i.e. the exaggeration or even misrepresentation of the social aspects of such bonds. Currently, 738 social bonds with a cumulative nominal value of USD 392 billion are available and the range of targeted funds is reasonably broad.
Development of social bonds
Sustainability bonds are used to finance a combination of green and social projects. These instruments made the headlines in August 2021 when Google’s parent company, Alphabet, raised USD 5.75 billion via several bond tranches. The offering was the largest sustainability deal in history and catapulted Alphabet into second place amongst the largest issuers of sustainability bonds. The proceeds from this transaction are to be used for environmental projects such as solar energy plants, as well as for social projects devoted to the construction of affordable housing. In this respect, the rules of the ICMA Sustainability Bond Guidelines (link) are authoritative. Currently, 802 sustainability bonds with a cumulative volume of USD 318 billion USD are available.
Development of sustainability bonds
Sustainability-linked bonds constitute a segment of their own, where no restrictions apply as to the use of the proceeds. Here, the investor’s return depends on whether the company actually achieves certain predefined, measurable sustainability targets relating to environmental or social factors. The yield on such bonds is linked to these sustainability metrics, and failure to meet them is penalised in the form of a higher coupon payout. Thus there is an incentive for the company to meet the targets.
Unusual as it is, this fascinating structure offers great promise. On one hand, the issuer retains a higher degree of freedom in how the funds are to be applied – the bonds can be issued just as well by borrowers from “dirtier” sectors that otherwise have no access to the specified-use-of-proceeds market. On the other hand, the investor has no certainty that the funds will be used for the desired purpose; in fact, it could be totally antithetical to their wishes. Sustainability-focused investors also need to look carefully at the prescribed targets to ensure that they are ambitious enough. At present, this market segment comprises 243 sustainability-linked bonds with a cumulative volume of USD 111 billion.
Development of sustainability-linked bonds
Impact bonds are still a young but nevertheless promising fixed-income market segment. They close the gap between traditional bond investments and philanthropy, depending on the strength of their impact in terms of sustainability. The heaviest demand at present is for investments that do not sacrifice yield but still have a positive influence (be it environmental or social) on the world in which all of us live. We expect to see a pronounced increase in the overall volume of this market in the years ahead.
Individual issue recommendations
Our bond selection process is based on VP Bank’s sustainability philosophy. We exclude issuers with a low ESG rating, problematic business activities or questionable practices. The proprietary VP Bank Sustainability Score (VPSS) shown for each borrower on our list of recommended bonds reflects how sustainable we consider the given issuer to be. This universe also includes impact bonds. Just like traditional bonds, these instruments must offer a compelling risk/return relationship and fulfil predefined liquidity requirements in order to be included in our recommendation list, which in future will highlight green and social bonds. Upon request, we shall be happy to generate a list that includes only those bonds.
For further product recommendations, please contact your customer advisor.
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