Sustainability is driving innovation in investment-grade credit. This is particularly visible in the euro-denominated market, although we expect that the Biden administration will encourage a sustainability focus in the USD market going forward. When talking about sustainability in the bond market, this means more than just green bonds. In fact, the green, sustainable, and social (GSS) bond market has grown exponentially and has diversified into many different sectors and types of bond structures. Over the past three years, the total notional value of the ICE BofA Green Bond Index increased by almost fourfold.
The market remains heavily weighted to the initial issuers of green bonds, namely utilities and financials, which still represent a disproportionate percentage of the index at 39% and 29%, respectively. But companies from other sectors are entering the GSS bond market with structures adapted to their requirements and addressing the increased demand from investors for sustainable business targets.
The innovation is being driven by issuers that are either in challenging sectors from a sustainability perspective (e.g., building materials) or that feel they don’t have sizable enough green projects to warrant a benchmark-sized green deal (e.g., Tesco). For these issuers that wish to convey their green credentials, sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs) may be the answer. Equally for investors, these bonds may meet their needs to move toward more sustainable investments.
A focus on outcomes
These SLBs focus on outcomes, with coupon step-ups that penalize issuers that do not meet pre-agreed sustainability performance targets (SPTs). By their very nature, these are forward-looking instruments with concrete targets, in contrast to green bonds where goals are less defined.
The International Capital Markets Association (ICMA) has drawn up process guidelines in an attempt to increase capital allocation to these products by clarifying the rules of play. While the use of proceeds are unrestricted, the guidelines are built around five core components:
1. Key performance indicators—tailored to the ESG challenges of a given sector
2. Calibration of SPTs—that go beyond “business as usual”
3. Bond characteristics—designed to be meaningfully different to plain-vanilla obligations
4. Reporting—required to be up to date and accessible
5. Verification—requiring independent and external verification
While the ICMA’s process guidelines were set out in June last year, Italian utility Enel was the first to test the SLB waters as early as September 2019 with a $1.5 billion five-year bond whose coupon steps up by 0.25% (25 basis points [bps; 100 bps equal 1.00%]) if the renewable installed capacity is below 55% of total installed capacity by December 2021. A follow-up deal in October 2019—in euros this time—was linked to a reduction in greenhouse gas emissions. While it’s essential to question how ambitious the targets actually are, we believe that issuance of SLBs and SLLs are a statement of intent and will dramatically increase over time.
Demand seen increasing with more technical support
We have seen green bonds priced with what is referred to as a “greenium,” meaning a premium to the issuers’ existing “brown” bonds that were not issued for designated sustainable purposes. Counterintuitively, however, SLBs have been issued at a discount to existing brown bonds. The reason for this is that the expansion of specialized green bond funds and portfolios tilted toward GSS bonds has created a squeeze in labeled bonds, but some investors are still unable to buy bonds with step-up coupons—including until recently, the elephant in the room, the European Central Bank (ECB).
In September 2020, the ECB announced (from January 2021) that bonds with coupons linked to sustainability-linked performance targets would become eligible as central banks’ collateral as well as eligible for asset purchases under their quantitative easing scheme. With both the ECB and the new U.S. administration likely to bolster technical support for existing bonds, even more issuers may be encouraged to use these innovative structures.
Portfolio Manager, WFAM Global Fixed Income
Alex Temple is a portfolio manager for the Credit Europe team at Wells Fargo Asset Management (WFAM). In this role, he is responsible for investment-grade-focused portfolios. He joined WFAM as a rates portfolio manager with the Structured Products Group, structuring derivatives for the firm’s pension fund and insurance clients. Before that, Alex was a vice president with the Global Debt Analytics group at Merrill Lynch in London, where he worked on the swaps and interest rate options desks for over six years. Earlier, he served as a consultant for LogicaCMG, specializing in the banking sector. Alex began his investment career in 2001. He earned a master’s degree with honors in mechanical engineering from Bristol University.
Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds. In general, when interest rates rise, bond values fall and investors may lose principal value. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform.