by Yoshie Phillips, Russell Investments
The labeled bond market has seen explosive growth in issuance over the past two years. In the first half of 2021, labeled bond issuance that aligned with the International Capital Market Association (ICMA)’s guidance reached over $600 billion, already exceeding the 2020 full-year issuance volume. The surging labeled bond market likely reflects investors’ appetite toward a more sustainable global economy. Government policies, such as the European Central Bank (ECB)’s asset purchase programs to include green bonds, as well as the EU’s regulations supporting transparency of green credentials for financial market participants, are also contributing to this demand.
What are labeled bonds?
Labeled bonds (sometimes referred to as impact bonds) are bonds that have specific environmental, social or governance (ESG) or sustainability objectives. The labeled bond market has the following five primary categories;
- Green bonds aim to focus on the transition toward a low carbon economy and are the largest component of the labeled bond market. Green bonds are bonds issued by countries or companies with the proceeds targeting specific environmental projects and opportunities.
- Social bonds focus on social impact, including affordable housing, access to finance and/or supporting small businesses. Social bond issuance has surged since the COVID-19 crisis, as the pandemic brought heightened attention to the importance of social issues. The proceeds must support certain social agendas.
- Sustainability bonds target a combination of green and social goals. We have observed that such sustainability bond offerings tend to link their investment opportunities with the United Nations’ Sustainable Development Goals (SDGs). The proceeds must support sustainability goals.
- Sustainability-linked bonds have their coupons linked to the issuers reaching predetermined Sustainability Performance Targets (SPTs) and Key Performance Indicators (KPIs). If an issuer fails to reach these targets by a given date, the coupon steps up or additional payment is due at maturity. The proceeds can be used for general corporate purposes.
- Sustainability-linked loans have their coupons linked to the issuers reaching predetermined Sustainability Performance Targets (SPTs) and Key Performance Indicators (KPIs). If an issuer fails to reach these targets by a given date, the coupon steps up or additional payment is due at maturity. The proceeds can be used for general corporate purposes.
How is impact measured?
The key feature in green bond, social bond or sustainable bond investing is the ability to understand how the proceeds are used and the ability to monitor the actual versus stated objectives. In the case of green bonds, the ICMA Green Bond Principles aim to provide a guideline for the use of proceed definitions. However, there is much subjectivity in the definition of what qualifies as green bonds in the marketplace.
In order to address this challenge, there are a growing number of independent opinion providers, such as Vigeo Eiris and Cicero, that now evaluate green bond programs. Audit firms are often involved in verifying the traceability of funds to the specified projects. Additionally, regular reporting is required to list green projects and disclose certain impact measures (e.g., energy savings and how much greenhouse gas was reduced). Having a well-defined investment framework and infrastructure to exploit the market, coupled with a robust reporting system, is an important consideration in impact investing. It’s important to note that the desire for portfolio transparency is greater in impact investing overall.
Sustainability-linked bonds and sustainability-linked loans, on the other hand, are not tied to specific projects and can be used for general corporate purposes. Sustainability-linked bonds and loans are newer instruments in the impact bond market and remain relatively small in volume, compared to other impact categories. Such bond issuers favor sustainability-linked bonds or loans due to flexibility—they do not have to be tied to specific projects and there’s less rigidity governing how their proceeds can be used. At the same time, these bonds still show their commitments to specific environmental or social outcomes. In Europe, there has been more sustainability-linked loan issuance than sustainability-linked bond issuance thus far, in part because the loan structure of associated spreads is easier to adjust than bonds’ fixed coupons—especially for below investment-grade rated companies.
What are some of the challenges?
As with all debt instruments, there are a few key challenges pertaining to labeled bonds worth paying attention to. The first is the issue of self-labeling. We believe it’s important to watch out for this, especially when it comes to the establishment of SPTs and KPIs. This is because some KPIs may not make much difference in a company’s sustainability efforts, as they might not have material impacts. Ideally, KPIs should be material to a business, and the associated performance measures—the SPTs—should have high standards. Another challenge is that many sustainability-linked bonds or loans have call options embedded, meaning that the debt issuer could call the debts before the KPIs materialize.
Valuation: Labeled bonds vs unlabeled bonds
The valuation of labeled bonds is worth highlighting here as well. Ultimately, the surge in labeled bond issuance has been driven by strong demand. In fact, demand has been so strong that the spreads between labeled and unlabeled bonds for the same company are now showing a clear trend, with labeled bonds often slightly more expensive than unlabeled bonds. This is referred to in the market as the greenium, and is likely due to the proliferation of ESG product offerings that prefer to invest in labeled bonds, creating a supply/demand imbalance that influences price. Amid this backdrop, the labeled bond market is expected to continue to grow.
Where are the opportunities?
The labeled bond market expansion provides greater diversification in this market segment. While the green bond market still accounts for more than half of the labeled bond market, the social bond market and sustainability-linked bonds or loans have also substantially grown in recent years. From an industry perspective, utilities and financials are the main issuers of green bonds, yet other sectors like consumer cyclicals (autos), technology, communications and basic material companies are also tapping the labeled bond market for their capital needs.
Companies whose business models lack a strong link to sustainable projects in their operations are also utilizing sustainability-linked bonds. In addition, many companies and governments across the globe are increasing their commitments to address climate risk. As a result, government entities, such as agency, supranational and local authorities, now make up a sizable portion of the green bond market, with Germany, France and Italy being the larger issuers. The green bond market expansion also includes green bond securitized products, from Fannie Mae’s mortgaged-based securities financing homes and communities that meet energy and water-savings standards to asset-backed securities in solar and auto sectors.
Furthermore, companies with below investment-grade credit ratings and emerging market countries are also issuing labeled bonds. Ultimately, bonds with green credentials are growing at a rapid pace across both governments and corporations.
The bottom line
Responsible investing product offerings continue to expand around the globe into the mainstream. The labeled bond market has seen rapid growth in issuance across five primary categories: green bonds, social bonds, sustainability bonds, sustainability-linked bonds and sustainability-linked loans. Green bonds offer greater transparency in regard to how the use of proceeds are applied, while sustainability-linked bonds or loans offer scientific-based measures for bond issuers. Overall, as with all investments, each is not without its own merits and challenges.
While the surge in labeled bond issuance has broadened the opportunity set for investors, the amount of scrutiny needed to determine what qualifies as a labeled bond has also increased, with heightened demand for data transparency and industry-standard practices. As is often the case, the devil here will be in the details. With this in mind, we believe that bond investors should be mindful of labeled bond investing, especially in terms of how impacts are measured, monitored and reported.
To find out more about key ESG integration trends that we are observing amongst fixed income practitioners, read out latest paper here.
