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Thursday 28 March 2024

As we step into 2024, inflation figures have significantly decreased from their peaks, and inflation is continuing to make progress towards central banks’ inflation targets. With current interest rates kept in place, real policy rates are beginning to pose constraints on economies. Consequently, there is an anticipation of substantial interest rate cuts by major central banks in the developed world this year, opening the door for additional volatility in bond markets. There is a divergence of opinions on the timing of these cuts, and the initial two months of 2024 have prompted a significant reassessment, causing expectations for rate cuts to be pushed back. The first rate cut in 2024 will signal the beginning of a new phase in this economic cycle and has the potential to impact markets on a broader scale. So, which central bank is most likely going to kickstart the cutting cycle? Here is my best estimation.


Source: Bloomberg, February 2024.

The Fed:

The latest FOMC core Personal Consumption Expenditure (PCE) inflation forecast anticipates significant disinflation in the coming year, with core PCE expected to decline to 2.4% by the end of the year. However, the new year began with higher-than-expected inflation data, raising doubts about the future trajectory of US inflation. Some of this increase might be attributed to seasonality, but Powell’s closely watched Consumer Price Index (CPI) core services, excluding shelter, rose to 0.85% in January, showing a re-acceleration across all sectors. This has pushed the 3-month and 6-month trend of Powell’s preferred CPI measure to 5.55%. When combined with a US real GDP growth rate north of 3%, an economy operating at full employment, and significantly eased financial conditions in the last quarter, the Fed has gathered enough economic indicators to maintain current interest rates until core PCE data confirms the disinflation path. However, it is important to note that some of the robust economic data are lagging indicators, and there are risks associated with the waiting game, as recent events in the banking sector, commercial real estate losses, and increasing consumer delinquencies have shown. While the likelihood of a rate cut in March has diminished, I believe there is a strong argument for the Fed to begin the process of gradually reducing monetary restraint by mid-year.

The BoE:

Shifting our focus to the next player in the race, the Bank of England. Recent reports have unveiled that the UK economy slid into a technical recession in the second half of last year. Additionally, it is common knowledge that the UK has limited fiscal leeway to reinvigorate economic growth. UK policymakers vividly recall the events of September 2022 when the Truss-led government proposed additional unfunded tax cuts on top of already high borrowing levels, sparking strong opposition from bond markets and the British pound. The BoE now faces a dilemma as inflation persists at elevated levels while growth remains subdued. Unlike the other contenders, the UK is the only economy where core inflation has not yet significantly dropped below the policy rate. Wage inflation, a crucial indicator, has not decelerated as swiftly as Bailey and his team had hoped. Recent data on the 3-month trend for regular average weekly earnings, showing a 6.2% increase year-on-year, surpassed economic forecasts. Compared to the other “racers”, I assign the highest stagflation risk to the UK. To pave the way for its first rate cut, inflation must further moderate, making it unlikely for the UK to win the cutting race. Nonetheless, while they might not be the first to cut, the BoE could implement more aggressive rate reductions at a later stage to bolster economic recovery, especially considering the limited fiscal space available.

The ECB:

The European Central Bank is an interesting one. ECB President Lagarde remains steadfast in her stance that it is premature to discuss rate cuts, yet market watchers increasingly disagree and anticipate a shift in the ECB’s narrative in the near future. This shift is primarily driven by economic data trends. Recent inflation prints slightly fell short of projections, confirming an underlying disinflation trend which, if sustained, would likely come short of the ECB’s end-of-2024 forecast of headline CPI at 2.7%. Furthermore, the chart below illustrates that the divergence in core inflation readings among the 20 member states has halved since September 2022.


Source: Bloomberg, February 2024.

The ECB is certainly welcoming the widespread decline in inflation prints across the Eurozone. While the rise in geopolitical tensions in the Middle East poses a potential threat to the positive inflation outlook, it currently remains a tail risk. However, the persistent weakness in economic activity extending into 2024 is a more pressing concern, as it could further add downside risk to the inflation outlook. Germany, the economic powerhouse of the Eurozone, continues to disappoint, with the German government recently revising down its 2024 real GDP growth forecast from 1.3% to 0.2%. Considering these factors collectively, I view the ECB as a strong contender in the race for the first rate cut, and I believe the ECB’s hawkish rhetoric will need to adapt soon to better align with  economic realities.

The SNB:

Moving on to our final contender, the Swiss National Bank. In all fairness, it appears that the SNB had a head start in this race. Swiss core inflation never surpassed 2.2% in this cycle, whereas the other contenders grappled with core readings above 5%. This can be attributed, in part, to the strengthening Swiss Franc, which once again served as a safe-haven currency during uncertain times, mitigating imported inflation pressures. Additionally, Swiss headline inflation was less affected due to a favourable energy mix, with local hydro power playing a significant role in the energy supply of the mountainous nation. Despite economists’ predictions of a rise in core inflation for January, the actual core inflation rate decreased from 1.5% to 1.2% year-on-year, now well below the SNB’s 2% target. In a recent interview with the Swiss newspaper NZZ, SNB President Jordan acknowledged that the Swiss Franc had begun to appreciate in real terms by late 2023. He highlighted the impact of this appreciation, which lowered the inflation outlook and posed challenges for some Swiss companies. The most direct tool to address the strength of the CHF would be interest rate cuts. Therefore, I perceive the SNB as the frontrunner most likely to implement the first interest rate cut among our four contenders, possibly as early as March this year.

As the four central banks near the finish line of our race, the question arises: which central bank has the endurance to deliver the inaugural rate cut? The stage is set for a thrilling finale, with hopes that inflation does not disrupt the outcome of the race.


Source: M&G, February 2024.

As outlined in a recent blog, bond investors have likely witnessed the final hike by the European Central Bank (ECB) of this economic cycle. With this in mind, investor focus might well shift to the ECB’s Asset Purchasing Programme. Bond investors should pay particular attention to the Corporate Sector Purchasing Programme (CSPP) following the ECB’s commitment to help managing and mitigating the financial risks of climate change by tilting or directing the ECB’s corporate bond purchases towards issuers with a better climate performance.

In March this year, the ECB disclosed details of their Climate Tilting Framework. As shown in the chart below, the climate approach focuses on a combination of backward-looking factors such as issuers’ carbon intensity, forward-looking metrics in the form of emission reduction targets, as well as disclosure quality standards. The climate score will then, among other risk factors, inform the ECB’s risk limits for their CSPP purchases.

Source: https://www.ecb.europa.eu March 2023.


The ECB has committed to decarbonise CSPP consistent with the goals of the Paris Agreement, which aims to keep the global temperature rise this century well below 2 degrees Celsius. The strategy so far was to tilt holdings towards issuers with better climate performance through the reinvestment of sizable redemptions. The ECB did acknowledge as part of the Climate Framework Disclosure that the large stock of existing holdings vis-à-vis reinvestments implies that it will take time for the tilting to have a substantial impact on the overall carbon metrics. So far so good, but here is where it gets interesting. The ECB halted their CSPP reinvestment in July 2023 as part of the run down strategy. Since CSPP represents 90% of the (circa €380bn) ECB holdings of corporate bonds, the process of decarbonising their portfolio via tilting the reinvestments essentially came to a halt. ECB President Lagarde acknowledged this in a July press conference by saying:

…we stopped any asset purchases under the Asset Purchase Programme, because we are no longer reinvesting. So as a result of that under the CSPP, we are not reinvesting. We are letting that portfolio into run-off mode. What we have decided is that we will stick to our commitment to be Paris Agreement-aligned, and we will in the course of 2023 elaborate the means and the ways by which we will be Paris-aligned.”
ECB President Lagarde, 27th July 2023

This leaves the ECB with only a few options:

  1. Passive approach: Accept a misalignment with their climate commitment for the time being until their holdings with a low climate score mature or until market conditions warrant reinstating either a reinvesting approach or expanding the CSPP programme.
  2. Active approach: Coordinated selling of holdings with a low climate score, and, depending on market technical, replacement of sold bonds by buying securities with a better climate score, also known as a stock-based tilting approach.

The ECB has a role model function to play: therefore my view is that the ECB feels obliged to pursue an active approach to ensure they stay in control and make further progress in mitigating the climate risks of their corporate holdings and achieving a Paris-aligned portfolio. Given the importance of the ECB as one of the largest buyers and sellers of corporate bonds, as well as  setting the blueprint for other market participants, it is paramount for fixed income investors to anticipate the ECB’s next move and to reflect this important market technical in the pricing of affected bonds. With that in mind, the M&G Fixed Income Team have worked with M&G’s Climate Team to approximate the ECB methodology using the disclosed information.

Source: ECB, M&G 2023. M&G model assumes equal security weighting. Green bonds and utilities receive scoring uplift.


While the distribution of the M&G model looks similar to the official ECB chart, it is important to note that various information gaps remain. While the ECB releases the held securities, no effective weightings are published. In the absence of any better information, our model assumes equal weighting of securities. Furthermore, preferential treatment is given to green bonds and utilities following ECB board member comments advising not to divest initially from those companies whose actions are particularly important in managing the green transition. It should also be noted that the ECB’s climate-related financial disclosures of corporate sector holdings dates back to January 2023, while our model used the latest available holding data published in September 2023.

We are most interested in securities that fall within the three lowest rated buckets, equivalent to the ECB bands 0 to 2, as we anticipate that those securities are more likely exposed to selling pressure should the ECB decide to move to a stock-based tilting approach. The chart below highlights our findings.

Source: M&G, October 2023. M&G proxy score of 50 equivalent to ECB bands 0-2. M&G model assumes equal security weighting. Green bonds and utilities receive scoring uplift.


In terms of CSPP holdings, our model suggests that basic industry, energy and healthcare are the sectors most prone to ECB selling pressure. French and German issuers seem to be most affected which is unsurprising given those two countries are home to the largest corporate bond issuers in Europe. Irish issuers seem disproportionally highly exposed at 9% considering their smaller share of overall ECB eligible bond issuance. In terms of credit ratings, it looks like BBB rated issuers are overly exposed. They make up 58% of the lower climate bands while BBB companies account for 48% of Euro Corporate Bond index. We estimate the average maturity of the three lowest rated climate buckets to be just below 5 years. My hunch is that, should the ECB decide to start stock-based tilting, the initial focus would be on shorter-dated bonds to avoid realising capital losses on longer maturities with a low climate score.

We will continue to update and re-calibrate our model as more information comes to light about the central bank’s climate approach. Even in the absence of further interest rate action, upcoming ECB communication will require close monitoring from corporate bond managers for various reasons, one of which is further hints on the ECB climate strategy.  

One of the most powerful tools Public Fixed Income investors have at their disposal to support the transition to a low-carbon economy is project financing via Use-of-Proceed instruments such as green or sustainability bonds. We have written in the past about the stellar growth of the ESG themed bond market over the past few years and we don’t expect this to change considering green funding plans around the world. The US plans to deploy $369bn in tax credits and direct subsidies to catalyse private investments in clean energy, transport and manufacturing on US soil as part of the Inflation Reduction Act, while the EU Commission has drafted its direct response to the US green funding plans via the proposed Green Deal Industrial Plan for Net-Zero age. This comes on top of the EU’s ambitious push towards a more independent and sustainable energy system.

Measured by issuance volume, Green bonds are by far the most popular ESG financing solutions in public debt markets. Green bonds are instruments that channel investors’ capital towards environmentally friendly projects. With real world impact in mind, supporting green bonds of otherwise heavy carbon-emitting issuers will accelerate the decarbonisation process and provide investors with the biggest bang for buck all else equal. In this blog, we take a look at how much bond investors have to pay up (the “Greenium”) for choosing green bonds, and the difference in the Greeniums of heavy emitters vs low emitters.

Calculating the Greenium

In calculating the Greenium, first of all we want to ensure we only look at green bonds that exhibit sufficiently high quality standards. We therefore only consider green bonds that are aligned with the standards of the Climate Bond Initiative or certified as such. This leaves us with slightly north of 300 green bond corporate issuers in the global Investment Grade space. For the purpose of this exercise, we create two tiers based on carbon intensity data to allow for comparison between companies of different sizes. On the one hand we have the high carbon intensive tier of green bond issuers, which features prominently sectors like utilities and automobile manufacturers, while, on the other hand, we find Banks and Technology companies well represented in the low carbon tier bucket.

Next, we analyse whether those selected corporate green bonds trade at a credit spread discount or premium: the Greenium. When trying to evaluate the Greenium, it is important to identify comparable green and non-green bond pairs. We consider matching bond pairs issued by the same issuer in the same currency. Further we screen for bonds with a minimum $300 million equivalent amount outstanding to reduce spread anomalies caused by smaller issues due to illiquidity. In addition, bond characteristics need to match coupon type, payment rank, credit rating and, last but not least, duration differences between the green and non-green bond pair needs to be within one year. Not all green bonds in our sample have a matching non-green pair that complies with our set requirements and we are left with 161 bond pairs in the high carbon emitting tier and 126 bond pairs in the low carbon emission tier.

Greeniums of high vs low carbon emitters

Source: M&G, Bloomberg, MSCI, March 2023.

When looking at the aggregated result one might be surprised. Not only is the equally-weighted Greenium of the high emitting tier close to zero with the average credit spread trading only 1.7 basis points richer than the non-green instrument, the Greenium is also lower than the one in the low carbon emission tier at 7.5 basis points. We also observe that the Greenium is slightly more pronounced in the US compared to Europe.

This leads me to two conclusions. Firstly, as I noted in my earlier blog, fixed income markets still struggle to price ESG bond instruments efficiently. Correct pricing of those securities is complicated by the differences in ESG bond framework standards and the required understanding of a company’s wider climate transition credentials. This is shown by the lack of spread premium evidenced for high carbon emitters compared to low carbon issuers, but also by the dispersion of Greenium results on a security level which remains large. Secondly, the result leaves me to believe that currently the Greenium in the space is partially driven by a scarcity premium. We note that Europe is leading the way in terms of ESG bond issuance as % of overall issuance, while other parts of the world offer less green bond choice thereby increasing the willingness of investors to pay up for green deals. The same pattern in regards to scarcity is starting to emerge when looking at a sector or issuer level.

Source: M&G, Bloomberg, MSCI, March 2023.

For example, while German utility company ENBW, a regular green bond issuer in the market, sees its green bonds trading at a wider level than comparable General Corporate Purpose bonds, pharmaceutical business Amgen’s only green bond trades at tighter spreads versus its non-green equivalent. While other factors can explain part of the Greenium on an issuer level, such as company specific dynamics or other instrument differences we haven’t adjusted for in our analysis, scarcity of green bond securities seem to play a role. At least it seems to be a bigger factor to explain relative richness or cheapness in credit spreads compared to a company’s carbon footprint – the reduction of which is a key purpose of green bond securities. The silver lining from this analysis is that active bond investors have plenty of opportunities to pick up credible green bond securities from high carbon emitting issuers relatively cheaply as a way of providing capital to companies under the condition that the proceeds are spent only via environmentally friendly projects. In other words, at least for now this allows bond investors to help accelerate the transition to a low-carbon economy at very little extra cost.

There are various interesting features linked to green bond instruments which are behind the surge of the green bond market. The defined project financing structure prevalent in green bonds allows money to be channelled to specific green projects. In addition, bondholders get additional transparency and reporting in the form of allocation and, more frequently, impact reports. A published green bond framework, which is accompanied by a second-party opinion affirming that the frameworks meets market standards such as the ICMA core principles, has become the market norm, but it does come at an additional cost to the issuing entity. These factors do conceptionally support a price premium for such instruments, also widely called a “greenium” – so too does the increasing demand for such instruments linked to the EU taxonomy.

Measuring the size of the greenium present in the market is not a simple exercise and research attempting to do so results in differing conclusions when trying to put a value to it. In my view, the cleanest way of analysing the greenium is by looking at matching bond pairs of the same issuer which share similar attributes around capital rank, currency, coupon type, duration and amount outstanding to avoid distortion due to illiquidity. Finding matching bond pairs however is not always easy, as issuers don’t usually issue ‘twin’ bonds, a concept where the green bond is identical in terms of cash flows and other bond features to a conventional bond. Twin bonds are however used by the German Finance agency which have issued some maturing in 2025, 2030, 2031 and 2050. Comparing the yield of these green bonds to its conventional twin therefore enables the greenium to be directly observed.

Germany’s green bond framework has been evaluated positively by second-party opinion provider ISS and the Bundesfinanzministerium has published an allocation report on green expenditures in May this year which underwent third party verification, both supporting the quality standards bond investors want to see. Furthermore, the German government recently published its first Impact report for green bonds issued in 2020, detailing the contribution that the green expenditures are making to climate protection, climate change adaption, mitigating environmental pollution and protecting biodiversity and ecosystems.

So how much extra do investors need to pay for owning such green bonds at this point in time? Not much in fact. The greenium of the DBR 0% 08/15/2030, compared it to its twin, has recently been flirting with zero, as shown in the chart below. Over the last year, the spread pick up from moving out of green into the conventional bond has fallen from 7bps to levels as low as 0.1 basis point (bps) reached in September 2022.


Source: M&G, Bloomberg (17 October 2022).

Moving to the UK, the Debt Management Office had its debut gilt offering approximately a year ago, raising £16.1 billion through two green gilt syndications. Second-party opinion provider V.E rated the UK’s Green Financing Framework as ‘robust’ and the UK’s ESG performance as ‘advanced’. Last month, the DMO published its first verified allocation report, stating that all the proceeds have been deployed with almost half of the amount raised spent on Clean Transportation projects. 27% of UK’s greenhouse gas emissions in 2019 were caused by domestic transport, the highest of any sector of the UK economy, making it a central area for reaching carbon neutrality by 2050.

The UK, as most green bond issuers, does not use twin bonds, so the best comparator we have available to assess the greenium is the UKT 4.5 09/07/2034. Admittedly, this is a bond with slightly lower duration (given the higher coupon structure) and larger amount outstanding, but all things considered it remains a decent proxy. Since the peak in July 2022 when the greenium of the bond pair reached 10 bps, things have changed quite considerably and investors at the beginning of October had the chance – for the first time – to pick up UK Gilt green bonds at a discount. 


Source: M&G, Bloomberg (17 October 2022).

There are a few technical reasons which can help to explain this move, e.g. green corporate issuance which let some bigger accounts sell the green gilts and move into corporate green deals, or the fact that the green gilts got caught in the midst of the Cheapest-To-Deliver battle for the future contract between the Gilt 32s and 34s. In any case, some of the latest price action we can observe in the green bond space illustrates that the greenium is far from static and does change over time, influencing the relative value of green bonds. It also shows that fixed income markets still struggle to effectively price green bonds versus non-green bonds. The same is the case for fully EU taxonomy aligned green bonds versus the partially aligned green bonds, but this is for another blog. For now, I stand by it: in green bond land, there is at times a free lunch available – which is good news for active bond investors.

The growth of ESG-themed bonds continues with no slowdown in sight. While project style financing for named projects or defined activities, particularly around environmental improvements via green bonds continues to see high demand, newer concepts such as Sustainability-Linked Bonds (SLB) show very high growth rates. SLBs offer an issuer far greater flexibility over how debt capital raised is used. As long as the company achieves certain stated group-wide sustainability improvements over the lifetime of the bonds, the money raised is available for general corporate purposes and is not restricted to defined investments. As a result, an increasing number of companies have been able to state that going forward, all their bonds will come in form of ESG-themed bonds. We have written in the past about the different flavours of ESG-themed bonds here.

Source: Dialogic, Bloomberg, Barclays Research

With company capital structures being financed more widely through ESG-themed bonds as shown in the chart above by Barclays, the question arises on how compatible ESG-themed bonds are with certain parts of the capital structure. In general, ESG-themed bonds are debt issuances where the credit-risk of the themed issuance is pari-passu with same seniority of ordinary bonds from the same issuer. The fact that bonds are issued with a subordinated payment rank is not causing a conflict of interest here, but in my view, subordinated debt with equity-like features requires a closer look. Corporate hybrids and subordinated bank paper in the form of Additional Tier 1 bonds (AT1) are good examples to determine if bonds with deeply subordinated payment ranks, can be married with ESG-themed bonds concepts.

Financials

Let’s start with junior subordinated bank paper, which often come in the form of Basel III compliant AT1 bonds. Such instruments are issued to meet regulatory capital requirements and include a feature whereby the bonds can be converted to equity or written-down should the Core Equity Tier one (CET1) ratio fall below a certain predetermined level or the financial institution be considered non-viable by the regulator. We would argue that bonds with an equity conversion or write-down feature show limited compatibility with the pre-defined project financing standards of use of proceed bonds such as green, social or sustainability bonds. Financial institutions issuing AT1s receive capital benefits, i.e. an improvement in regulatory capital ratios, which do not have any requirements from a green or social perspective. By design, AT1s are instruments to support the entire broader balance sheet at point of issuance and therefore run the risk that the intended green or social project financing is not followed through, should a conversion trigger or a write-down kick in.

The more flexible concept of SLBs comes with other complexities, particularly in subordinated situations, mainly related to the contractual financial penalty in form of coupon step-up and/or a redemption premium should the Sustainability Performance Targets not be achieved. In our view, a case can be made that the option of a financial penalty can provide an incentive to call, something that needs to be avoided when structuring equity-like financial debt. An opinion provided by the European Banking Authority (Report on the monitoring of Additional Tier 1 instruments of EU institutions.pdf (europa.eu)) supports this view as it suggests that sustainability-linked features do contradict the requirements of the Capital Requirements Regulation (CRR) for a security to count as AT1. Features like accelerated payment rights or incentives to redeem would not be allowed, amongst other things.

Corporates

Moving on to corporate hybrids. As a quick reminder, hybrid bonds allow the issuer to have choice over exactly how the instrument is presented in its financial accounts. Perhaps more important from a credit perspective, the instrument also receives partial equity treatment (typically 50%) from credit rating agencies under certain conditions. While not true equity as subscribed by shareholders, the equity equivalent recognition of hybrids supports the issuer’s credit rating and thus helps with debt market access. To receive partial equity treatment from credit rating agencies, hybrid bonds require loss absorbing qualities to protect senior debt, including the ability to conserve cash via coupon deferrals, and they also need to embed a permanence feature.

Similar to subordinated financial bonds, I believe that SLB features clash with the original concept of corporate hybrids particularly when aiming for credit agency equity treatment. In this case, the instrument’s ability to provide an additional cushion for senior tranches via cash conversion required by the credit rating agencies, interferes with the increased financing costs that can be triggered by not achieving the sustainability targets. One potential solution to this could be to structure an SLB with very ambitious Sustainability Performance Targets which, if successful, triggers a coupon step down. This would likely be seen as acceptable by credit rating agencies as it doesn’t work against the cash conversion features of hybrids. Whether issuers could secure demand from investors for such an instrument remains questionable, however. Even if so, I believe it is generally harder to marry a permanence feature prevalent in hybrids with Sustainability Performance Targets and related trigger points along the lifetime of the bond. Interestingly, we’ve seen examples where companies have committed to issuing only SLBs going forward only to issue hybrids the following year, neither of which included any sustainability-linked features.

Use of proceed hybrid bonds, whether green or social in nature, lead us to a different conclusion, as the financial terms will not change unexpectedly over the lifetime of the bond to the detriment of senior bonds. In addition, and opposed to subordinated bank debt, hybrid bonds do not have equity conversion or write-down features which is a key difference. Hybrids also do not come with any regulatory benefits compared to AT1s. As a result, the defined project financing cannot be derailed as is the case with convertible features prevalent in Basel III compliant AT1 bonds.

The question is “Do bond markets agree with our thinking?”. Looking at current market trends, we can see this pattern holding for now. Sustainability-linked features remain absent in the deeply subordinated bond space. One area where bond markets tend to disagree with us is on AT1s where financial institutions have been successful in issuing use of proceed instruments in the form of green and sustainability bonds. More evidence that views from market participants continue to differ, as the exciting ESG-themed bond market continues to take shape.

Source: M&G and Bloomberg

For public debt market participants, running a well-diversified portfolio with holdings that can be credibly classified as generating environmental or social impact can be challenging. One reason for that is that most of the sizable issuers in the public debt space are mature businesses as opposed to newer business disrupters that can be found more frequently in the equity space. In debt markets, it is private debt that is more naturally suited for project-based impact financing.

Having said that, the ESG-themed bond market, which is growing incredibly fast, provides a tool for public debt investors to achieve a positive contribution to environmental or social challenges. ESG-themed bonds are too big to ignore. To put some numbers on it, global ESG bond supply from corporate issuers totalled USD 707 billion in 2021, a growth rate of 225% versus 2020 issuance. Basically, every fourth euro printed in 2021 from euro investment grade companies has come with an ESG label to market.

Sustainability-linked bonds (SLBs) had their breakthrough in 2021 with more than USD 105 billion worth of paper issued, representing 15% of all ESG themed bond issuance. A year earlier, in 2020, the concept was hardly used, with SLBs representing only 3% of total ESG-themed bond supply in the corporate space. Going forward, I expect the SLB market to be the fastest growing segment measured in percentage year-on-year growth. There are good reasons for this, as I explain below. Investors who want to stay on top of public fixed income markets need to look at sustainability-linked bonds now.

Source: M&G, Bloomberg, February 2022. *issues below $100m excluded

SLBs versus classic green and social bonds

From a corporate perspective, the key advantage of SLBs versus classic green or social bonds is that proceeds do not necessarily need to be spent on defined environmental or social projects (which is the case for green and social bonds). Rather than committing to a specific use of proceeds, the company does commit to achieving certain sustainability improvements on a corporate level. Such improvements are often related to a reduction of the company’s carbon footprint or improvements on health and safety measures for employees.

This concept is particularly useful for issuers with smaller capital structures that might struggle to identify enough green investment projects that can qualify for a green bond issue. Unsurprisingly, the SLB structure has been embraced particularly by high yield issuers – typically companies with smaller capital structures, and therefore raising debt less frequently than investment grade issuers. Roughly 40% of total SLB supply last year was issued by companies with a high yield rating.

Source: M&G, Bloomberg, February 2022. *bonds with no Bloomberg composite credit rating are excluded from analysis

For bond investors, SLBs have potentially a much greater reach given that they directly address the corporate strategic alignment to sustainability. While green bonds give investors certainty about the proceeds spent, the proceeds might reflect only a small part of a company’s overall capital expenditure. In addition, Sustainability-linked bonds generally build in a financial incentive for the issuer to achieve certain ESG-related goals by a certain date; otherwise, a coupon step-up and/or redemption premium step-up will apply to the issuer’s bonds, compensating bond investors for a lack of sustainability progress.

While the ESG-themed bond market is still evolving, we can observe interesting price patterns. While investors are still paying a premium for owning green bonds (often referred to as “greenium”) – something which can be explained by supply/demand imbalances (e.g. efforts to increase EU taxonomy aligned exposure of funds) – SLBs do not show the same pricing patterns. Often SLB’s trade in line with the non-ESG bond curve, in rare cases even at a discount which makes them more attractive for relative value bond investors.

SLB sustainability-targets must be assessed carefully

The financial elements of those deals are typically straightforward and well flagged at point of issuance. However, there is an element of increased complexity in assessing the ambitiousness of the sustainability performance targets, as well as the relevance of any financial penalty that is triggered by a company not delivering on these targets. A key downside to the flexible structure of SLBs is that it is much harder for bond investors to define a market standard. A sustainability Key Performance Indicator (KPI) set in the company’s SLB framework should be relevant and material to the issuer’s underlying business model.

Sustainability Performance targets, which trigger a coupon step up should they not be met, need to be well-calibrated, ambitious and, should the company target climate-related KPIs, be aligned with a pathway to reach the Paris Agreement’s 1.5 degree goal. Coupon step up levels and trigger points need to be structured in a way to make them financially relevant to the lifetime of the bond. To assess the quality of sustainability-linked bonds, a full understanding of the issuer’s business model is required that goes beyond just financial metrics, something that requires credit research resource.

Watch out for greenwashing

Unfortunately we still see too many unambitious deals being priced in the SLB space. We have come across deals where not only the step-up date falls after the end of the non-call period for the bonds, essentially allowing issuers to call bonds before a coupon increase can take place, but also without a KPI-related redemption step-up built into its call schedule. We have seen an SLB deal of a pipeline business which focused on social targets, rather than committing to Scope 3 emission reductions and tackling pipeline leaks, which would be considered more material for the business model. We have also seen an SLB deal being priced from a high yield issuer where a failure to achieve a Sustainability Performance Target would have resulted in a minor coupon increase of only 0.125% per annum, with a trigger point relatively close to maturity – a step-up representing a fraction of the companies refinancing costs in the market, making the financial penalty almost irrelevant. In summary, the SLB market has to mature further and I am convinced its natural evolution is going to happen.

At the current stage, however, I consider the greenwashing risk to be bigger for SLBs than for green bonds. It seems that for now there is enough demand for SLB bonds from non-ESG minded investors, who can overlook the sustainability side of such deals. What is needed is more constructive dialogue between buy-side investors and Debt Capital Market desks, and push back from bond investors to issuers on insufficient deal structures. As with all ESG-themed bonds, we should always remember these deals are self-labelled and can fall short of expectations. Therefore, a quality assessment is needed to assess the potential greenwashing risk (or social-washing in regards to social bonds). While second party opinions help, they can be overly generous with the issuer at times. Further scrutiny is required too to assess the corporate strategic alignment of such ESG-themed bond deals.

The SLB market will soon be too big to ignore

As mentioned earlier, I am the view that the SLB market will soon become too big to ignore. We see an increasing number of companies announcing that all their future issuance will come in form of sustainability-linked bonds. It also allows companies for which the core of their business is not (yet) compatible with green financing (think about an oil & gas transportation business, which pursues energy efficiency programmes by installing heaters with more efficient technologies to reduce methane emissions) to tap into a growing sustainability-minded investor base. Bond investors will likely see much more SLB investment choice coming from various sectors with issuance across the whole credit quality spectrum, but those investment opportunities need to be carefully evaluated to assess greenwashing risks.

Summary: ESG-themed bonds are gaining increasing market share – so much so that they can no longer be ignored by fixed income investors, whether you run sustainable portfolios or not. We wrote earlier this year on the various forms of those ESG-themed bonds that have come to market. For starters, ESG-themed bonds are those in which the credit-risk of the issuance is pari-passu with same-seniority ordinary bonds of the issuer. What makes them special, however, is that such bonds actively drive positive environmental and social outcomes via clearly-defined rules around the use of proceeds or, in the case of sustainability-linked bonds, that the corporate entity targets defined sustainability improvement during the lifetime of a bond.

With the first half of 2021 having just come to a close, the timing couldn’t be better to take stock and analyse the supply dynamics of these ESG-themed bonds. In the first six months of 2021, investors saw corporates issuing new ESG bonds worth $350 billon. Helped by generally strong issuance this year, this year’s ESG bond issuance already surpasses the supply of ESG bonds over all of 2020.

Source: M&G, Bloomberg, June 2021 – issues below $100m excluded.

Green bonds continue to be the most utilised for corporates, with issuance standing at $169 billion year to date. The real estate, utility and banking sectors were responsible for 33% of the green bonds issued this year. In second place, social bond issuance is trending at $81 billion and is dominated by supranationals and banks, both well-placed sectors to support social projects such as social housing developments. A further $64 billion has been issued in the form of sustainability bonds (which finance projects with a combination of environmental and social goals), a concept that is gaining increasing popularity in the US.

To put these numbers into context, ESG bond issuance in 2021 comprises 26% of total EUR investment grade corporate supply. In other words, every fourth Euro raised in EUR investment grade was issued with certain environmental or social targets. High yield ESG bond-themed issuance in 2021 is also worth 20% of total EUR high yield supply, revealing the wider use of the green bond concept by EUR high yield issuers.

Source: M&G, Bloomberg, June 2021 – issues below $100m excluded.

What has caught many investors’ attention the most in 2021 is the rapid rise of sustainability-linked bonds (SLBs). These bonds, which link coupon payments to clearly-defined targets at a corporate level, accounted for 10% of total ESG corporate bond issuance volumes year to date, compared to only 3% in 2020. So far, most of those sustainability KPIs are linked to environmental metrics which are arguably easier to measure than social ones. High yield issuers have started to embrace the SLB structure in 2021 too. As shown in the chart below, one third of the sustainability-linked bond supply in 2021 came from issuers with a high yield credit rating; prior to this, high yield SLBs have been non-existent. An increase in take-up doesn’t come as a surprise given that the embedded flexibility around the Use of Proceeds linked to SLBs is more suitable for high yield companies, given their generally smaller capital structures and that they raise debt less frequently than investment grade issuers.

Source: M&G, Bloomberg, June 2021 – issues below $100m excluded.

With more supply comes even greater need for quality assessment. We need to remember that ESG-themed bonds are self-labelled. Bond investors need to perform additional due diligence to ensure that the ESG targets set are in the spirit of their investment philosophy. Last month for example, a US meat producer that recently pleaded guilty to US foreign bribery charges came to market with a sustainability-linked bond. It is debatable whether a company with severe governance issues should tap the market with sustainability-linked bonds, and investors need to be aware of such potential conflicts. The same goes for the deal structure of ESG-themed bonds. Earlier this year, a French high yield issuer brought a SLB to market with a coupon step up of only +12.5bps. It is hard to justify such low coupon increases unless combined with highly ambitious Sustainability Performance Targets which, in the view of many market participants, was not the case in this instance.

Having said that, the increase in supply brings welcome diversification to the ESG themed investment universe by sector, region and credit rating. It will also help to improve secondary liquidity of those instruments and address some supply-demand imbalances that currently exist and can lead to an ESG bond valuation premium. If the current trend continues, the scene is set for another impressive round of ESG-themed bond issuance in the second half of 2021. Bond investors, stay tuned.

Summary: A few days ago, the summer version of the annual World Economic Forum was cancelled due to the worsening COVID-19 situation in Singapore. As a result, we may need to wait slightly longer for an update of the Global Risks Interconnections Map

As bond investors, it’s important that we can adequately price the underlying risks of an asset, considering the various non-financial risks that can impact the economic performance, which can in turn affect the value of an investment.

The map below illustrates how global risks are interconnected and brings to light why climate risk has emerged as the most important ESG factor for institutional investors. In short, a failure to solve the climate crisis affects investors in multiple ways.

Source: World Economic Forum Global Risk Perception Survey, 15th January 2020
https://reports.weforum.org/global-risks-report-2020/survey-results/the-global-risks-interconnections-map-2020/#risks

Climate change is defined as a change of climate which can be attributed to human activity that alters the composition of the global atmosphere in addition to natural climate variability. Climate change disproportionally affects the most vulnerable part of the population, through various avenues such as food insecurity, adverse health impacts or population displacements.

The Bloomberg Agricultural Commodity and Livestock index is trading up +20% since the start of the year and approaching its 5 year high, bringing these dynamics to the forefront of investors’ minds. Arguably, this time around, the rise in food prices is largely a result of pent up demand as economies around the globe start to reopen following government enacted lockdowns. However, part of the price increase can also be explained by supply constraints related to challenging weather conditions. With food being a significant component of the emerging markets consumption basket, history has shown frequently how higher food prices can impact economies, particularly those heavily reliant on food imports. For example, ten years ago, the world witnessed an unprecedented wave of civil protest known as the Arab Spring. The revolution came at a time when food prices started to rise, intensifying various other social issues in the Middle East. A paper written by the New England Complex Systems Institute argues that there is a direct link between the dates of riots in the Middle East and the price of food. While high global food prices on their own are unlikely to be a reliable indicator of social unrest, it can however be an important variable when it coincides with other economic challenges such as rising unemployment, limited fiscal policy space or high income inequality. Back in 2011 when the riots in Egypt intensified, the country was experiencing double-digit unemployment as well as rising inflation. The result of the uprising is well known: a prolonged period of social unrest which led to increased market volatility and a spike in credit risk premia.

Source: New England Complex Systems Institute, https://arxiv.org/abs/1108.2455  2011. Bloomberg, 25 May 2021

Environmental issues can feed through to economic risks in multiple ways, which is demonstrated via the interconnections map. For example, the failure to mitigate climate change results in more frequent extreme weather events (droughts, wildfires, flooding), leading to a food or water crisis. Large-scale involuntary migration can then lead to a worsening of interstate tensions which, in its worst form, can potentially lead to conflict and terrorist attacks. This, in turn, can affect the stability of an economy, lead to a rise in unemployment, affect political stability and impact the economic output, all resulting in higher risk premia for bonds. While there are certain economies directly exposed to climate risk such as Zambia, a country which generates 90% of its energy via hydroelectricity, most countries are indirectly impacted by climate change via other channels.

Given climate change is such an intricate topic, it is hard to capture the adverse impacts of inaction and I would argue that traditional financial risk models do struggle to capture the complex nature of such non-financial risks. The WEF interconnections map helps to untangle some of it, highlighting why major economies around the globe are ramping up climate actions with new regulations. The UK has committed to a net-zero carbon emission target by 2050, and so has the EU via its green deal which targets a bloc wide goal of net zero by 2050. Last year, China pledged to become net-zero by 2060 and on day one of President Biden’s term, the US re-joined the Paris Agreement and set a course to tackle the climate crisis by reaching net zero emissions economy-wide by no later than 2050. Such commitments from economic power houses come with new regulations and new opportunities, both directly impacting the competitive landscape of many companies. Assessing the impacts of this for corporate valuations should, in my opinion, be a priority for every bond investor, in order to properly assess the risk-reward of each individual security and understand the correlations as well as potential shocks to every bond portfolio – consulting the WEF Global Risks Interconnections Map is a welcome step in this process.

An abridged version of this article first appeared in Investment Week (print edition, 1 February 2021, p. 14)

The past five years have seen an exponential increase in investors’ ESG awareness, and corporate issuers are increasingly finding new ways to take advantage of the demand for sustainable investments. In the world of fixed income, one concept which has gathered plenty of attention has been the growth of green bonds.

While most investors are now familiar with these bonds, they are by no means the only way to gain exposure to ESG-labelled bonds. Recently, corporate issuers have sought innovative ways to access increasingly ESG-conscious capital markets, with new concepts such as transition bonds and sustainability-linked bonds. And over the past year, COVID-19 has brought a new need for governments and companies to mitigate social risks, leading to the rapid rise of social bonds in 2020.

The first thing to note is that most ESG bonds are characterized by their targeting ESG-friendly projects with their proceeds: the issuer itself does not necessarily need to have strong ESG credentials. Having said that, it is becoming increasingly difficult for bond issuers to access the market with ESG-labelled bonds when their corporate strategy is misaligned with those objectives.

Secondly, it is a market which is self-labelled: following governance and reporting practices set by bodies such as the International Capital Markets Association (ICMA) is voluntary. This means that bond investors need to perform some due diligence to ensure that the ESG targets set are in the spirit of their investment philosophy.

Enough of the technicalities for now. Let’s explore the various forms of ESG bonds which are continue to take up market share.

Green bonds

Green bonds are the most established part of the ESG bond market. The proceeds of these bonds finance environmentally-friendly projects such as renewable energy projects or electric vehicle charging stations. Last year saw green bond issuance of as much as $182 billion, including some inaugural emerging market (EM) issuers like Egypt (which became the first country in both Africa and the Middle East to issue a dollar sovereign green bond). Such issuance from EM and high yield issuers adds welcome diversity to the green bond universe, which is still tilted to highly-rated issuers, predominantly banks and utilities.

I expect the green bond market to grow even further in 2021 and beyond, boosted by the European Green Deal, China’s pledge last year for carbon neutrality by 2060, as well as US President-elect Biden’s $2 trillion green energy and infrastructure plan – the latter now supported by the Democrats’ control of the Senate. Furthermore, ECB members have mentioned more than once that climate change is a price stability risk and therefore a primary objective for the European Central Bank. With monetary and fiscal policy being increasingly joined-up in Europe to tackle the challenges of the zero bound, some form of green bond QE cannot be ruled out either.

Social bonds

The proceeds of social bonds go to projects with positive social outcomes such as providing access to education, affordable housing or improving food security. According to the ICMA principles, such social projects can also include COVID-19-related healthcare and medical research, vaccine development and investment in medical equipment. It comes as no surprise that social bond issuance in 2020 surged to fight the pandemic. In April 2020, Guatemala became the first country to issue a sovereign social bond aimed at financing COVID-19 response efforts. Corporate social bond issuance is on the rise as well as pictured below.  

Annual corporate ESG bond issuance is at a record high

With consumers now more attuned to social issues, social bonds provide companies with an instrument to demonstrate support for their wider stakeholders, from employees to customers and local communities. In 2020, social bond issuance reached $78 billion, an increase of 900% versus the previous year. As highlighted by S&P in a recent research note, the growing nature of such bonds does come with challenges for the industry. As opposed to green bonds, where quantitative improvements can be traced fairly easily, the outcomes targeted by social bonds are more qualitative in nature. This makes monitoring the impact of social bonds challenging and calls for improved reporting and disclosure practices to prevent so-called social washing – the practice of an issuer misrepresenting the social impact of its financed projects.

Sustainability bonds

Sustainability bonds are used to finance a combination of green and social projects. These bonds made headlines in August last year, when Google’s parent company Alphabet issued a multi-tranche deal worth $5.75 billion. The issue was the largest sustainability deal in history and catapulted Alphabet up to become the second-biggest sustainability bond issuer, accounting for 8% of the sustainability bond market. The proceeds of this deal will be used for environmental projects, such as making Google data centres more energy efficient, mitigating carbon emissions linked to transportation or maximizing the reuse of finite resources across operations, products and supply chains. Social projects include building at least 5,000 affordable housing units or providing financing for small businesses in Black communities.

Transition bonds

These ESG bonds are securities issued with the purpose of enabling a shift towards a greener business model. In particular, they are an instrument which allows so-called brown industries to transition towards a greener future. As I have argued in a previous blog on transition bonds, achieving a low-carbon world requires existing businesses, and in particular brown industries, to decarbonize and mitigate climate risk. While it would be a stretch for a coal-heavy utility company to issue a green bond, a transition bond can be used to accelerate investments towards a greener future.

As with green bonds, social bonds and sustainability bonds, transition bonds have the advantage of defined use of proceeds. This could open a wider investor base for energy companies that use the framework of transition bonds for low carbon activities such as renewables, green hydrogen or Carbon Capture, Utilisation and Storage (CCUS). In 2020, I counted four such transactions from three issuers. Those include Cadent Gas (the UK’s first transition bond), Etihad Airways and Italian gas transportation business Snam, the latter issuing transition bonds twice last year.

Blue bonds

Blue bonds are a subset of green bonds, those used specifically to finance projects related to ocean conservation. This includes managing plastic waste, but also promoting marine biodiversity by ensuring sustainable, clean and ecologically-friendly developments. As with green bonds, blue bonds follow the associated ICMA principles. Blue bonds are probably the most niche of the ESG bonds I survey: at the end of 2020, we have still seen only the fourth blue bond ever issued globally, following issuance from the Seychelles in 2017, and the Nordic Investment Bank and the World Bank in 2019.

Last year’s issuance from the Bank of China was a landmark, as the $942.5 million-equivalent deal was both the first blue bond from the private sector and also the first blue bond from a commercial bank. Whether this will be the catalyst for more blue bond deals remains to be seen. However, considering our growing global population, rising sea levels and change in dietary habits, it wouldn’t surprise me to see more activity in this area as our reliance on sustainable oceans is set to increase. Already, the market value of marine and coastal resources and industries is worth $3 trillion per year or about 5% of global GDP as estimated by the United Nations.

Sustainability-linked bonds

Sustainability-linked bonds (SLBs) work somewhat differently in the sense that there are no restrictions on the use of proceeds. What matters here is the company’s meeting certain predefined sustainability targets which can be related to environment or social aspects. Hence, it is an approach that moves away from specific activities and puts in focus the sustainability performance of an issuer. The coupon of sustainability-linked bonds is linked to some sustainability performance indicators – not meeting the sustainability commitments would result in a coupon step-up.

This is the ESG bond structure to which I would assign the biggest growth potential for the coming years. The lack of restrictions gives the issuer more freedom on how to spend the proceeds and lets the issuer pursue high profile goals on a company level, such as alignment with the Paris Agreement. SLBs are also more inclusive to issuers than the usual Use of Proceeds structure, and can work well for smaller companies and those in ‘dirtier’ sectors that have been unable to access certain parts of the Use of Proceeds market. The flip side to this is that lenders have no certainty on how those proceeds are spent – they could even end up supporting carbon activities. SLBs require a look beneath the surface to ensure that the performance indicators set are ambitious enough to tackle climate risk, as highlighted by my colleague Charles de Quinsonas in a recent blog.

The EU’s €750 billion recovery fund can be considered a major political achievement for the bloc. It’s good news for investors too, as the announcement helps to contain EU break-up risk as a result of Covid-19.

The plan has also received a positive reaction from green investors: the recovery fund can direct resources not only to hard-hit sectors, but also to sectors not directly affected by the virus, such as green technology and infrastructure. It is not yet clear how much of the EU’s future issuance will be dedicated to green bonds, but I would not be surprised to see the EU use its flexibility to help drive its target to become the first carbon neutral continent by 2050. This would certainly give a much needed boost to the green bond market, whose year-on-year growth story came to a halt in 2020.

Green bonds could serve as an attractive risk-free asset with a pickup

I would expect to see a good level of market interest for EU green bonds (subject to pricing), with demand coming predominantly from passive investors and investors with strict mandates for high quality assets. EU green bonds are anticipated to have a AAA credit rating and could therefore offer an interesting alternative to existing risk-free assets, such as German bunds. However, while the EU will become a sizable issuer of debt over the coming years, the total amount of EU bonds outstanding will still represent just a small fraction of outstanding German bunds.

I would therefore expect EU green bonds to trade with a small liquidity premium over bunds. There is also an element of redenomination risk embedded in bonds issued by the EU, which should also be reflected in some spread premium. EU green bonds might therefore appeal not only to sustainable bond investors, but also to portfolio managers looking for risk-free assets with a small yield premium. Furthermore, with the possibility of the ECB using its asset purchasing scheme to pursue green objectives, we could also see an interesting technical factor at play.

A catalyst for further issuance

How governments spend money is always a political decision. Since green bonds specifically address issues of ethical finance and long-term sustainability, they might help to increase the willingness for an increase in debt levels as a way to stimulate economic growth through investing in environmentally-friendly projects. Therefore, I would expect to see more countries join the current green bond leaders found in France, Belgium, the Netherlands, Chile and Ireland. Apart from Germany, which plans to issue its first green bund via syndication in September this year, Spain and Denmark have also recently shown interest in issuing green bonds. After all, green bonds are a way both to promote environmental objectives and provide economic stimulus.

From a bond investor’s perspective however, what is needed is a more diversified green bond market. Taking the Merrill Lynch Green Bond Index as a proxy, the limitations faced in constructing a portfolio come to light (see chart below). Fifty percent of the Green Bond index is rated AA or higher. When looking at the sector breakdown, 49% of the issuers are either sovereigns or quasi-sovereigns, with utilities and banks claiming 21% and 16% of the remaining index weight respectively. The key will be to deepen and diversify the market further. As things stand today, there are still challenges from a risk-return perspective, as it is hard to build a liquid and well-diversified portfolio with sufficient credit risk with only green bonds. Doing a quick Bloomberg search, there are currently only 55 bonds (from 36 issuers) with a high yield Bloomberg composite credit rating.

That said, corporations are becoming more aware of the possibilities that the green bond market offers. Just this year, we have seen BBVA issue its first CoCo green bond. Arguably, this opens up a debate over whether a bond should be used as capital instrument as well as a green-financing tool. In my view, it all comes down to the use of proceeds and transparency, and we can expect the EU taxonomy to provide greater clarity in this area.

We could see green EU bonds as early as 2021

So when will investors be able to integrate the EU green bonds into their portfolios? For now it is hard to say. As far as the Recovery Fund deal is concerned, there are still some hurdles to overcome in the form of parliamentary ratification. Assuming all goes well, the first batch of issuance is scheduled for early 2021, but it is not yet clear whether this will include EU green bonds. Assuming it takes 2-3 months to prepare issuance, we could get more information on this as early as Q4 this year. Before that, the EU may start to issue bonds for the SURE (Support to mitigate Unemployment Risks in an Emergency) programme as soon as September. However, I think it’s unlikely those instruments will be issued as green bonds given that their proceeds will be used to address the immediate challenges of the pandemic, rather than to fund environmentally-friendly projects.

Another point to consider is that the technical working group, which is assisting the EU Commission in the development of the EU taxonomy as well as the EU green bond standard, is still defining the screening criteria for certain segments of the market. Therefore, we might need to wait a bit longer until we see green bonds issued in scale by the EU. Nevertheless, according to Morgan Stanley research, the EU could potentially issue a total of between €800-900 billion by 2025 if all monies were to be fully utilised and disbursed. Part of this new issuance will almost certainly come to market as EU green bonds.

Author: Mario Eisenegger

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