Rise of sustainable bonds

05 June 2020

5 minute read

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

The COVID-19 pandemic will likely lead to a stronger focus on bonds of companies with sustainable strategies and business models. That said, for investors using ESG considerations, ensure coupons and capital repayments are based on a solid foundation.

There was a record supply of green bonds in 2019, lifting their overall stock to over $500bn, not considering those denominated in local emerging market currencies. The overall demand for sustainable investments accelerated too.

ESG focused exchanged-traded funds and mutual funds, in both equities and fixed income, saw inflows of over $20bn in 2019, four times as much as the previous years, according to investment researcher Morningstar.

Post COVID-19 era

Issuance of green bonds has been subdued of late. In March 2020 global green issuance was at $3.3bn, down from $16bn in February. Many companies have focused on securing funding for the whole business rather than a specific area, like environmental projects. Besides, stricter budget constraints have been needed, while green bonds usually fund new expansion capital expenditure (capex) plans. But this situation is likely to change once corporates have their contingency plans in place.

The recent pick up in issuance of green bonds confirms the above trend, with issuance in April and May of $16.9bn and $14.6bn respectively. According to the Climate Bond Initiative (CBI), total issuance volume is expected to be $350bn this year, compared to $257.6bn last year. While the number seems ambitious a rising trend of issuance seems very likely.

Pandemic crisis effect

Most governments globally have plans in place that aim for a sustainable recovery. During the recent virtual Petersberg Climate Dialogue, International Monetary Fund head Kristalina Georgieva emphasised this: “If this recovery is to be sustainable—if our world is to become more resilient—we must do everything in our power to promote a “green recovery.”

This was echoed by many leaders including the UN Secretary General, António Guterres. He said that the “recovery from the pandemic offers an opportunity to steer our world on a more sustainable and inclusive path”.

Europe plans to mobilise €1.1tn in the next decade for sustainable investments through its European Green Deal Investment Plan, which is part of the broader “Green Deal”.  In addition, Europe has launched a new stimulus programme worth €750bn in response to the COVID-19 crisis, separate from the latter initiative. To access the funds, member states must demonstrate that investments will be in line with the Green Deal.

Sustainability redefined

The pandemic crisis has prompted a broader definition of what can be considered social and sustainable investments. Most recently, the International Capital Market Association refined its sustainable funding definition: “Eligible social projects can include for example COVID-19-related expenditures to increase capacity and efficiency in provisioning healthcare services and equipment, medical research”.

While sovereigns must manage funding discrimination, companies which commit to ESG targets are likely to find it easier to find funding support. This should provide institutional investors with more confidence to invest in the respective issuers.

Can green bonds outperform?

While the green and sustainable bonds markets are more than 10 years old, its popularity has only accelerated in the last few years. This makes it difficult to analyse their performance.

The Bloomberg Barclays MSCI Global Green Bond index has outperformed its conventional counterpart by 2% in excess returns (over comparable sovereign bonds) since 2015. That said, the composition of both indices varies in duration and sectors.

It remains to be seen if green bonds in isolation will automatically lead to outperformance. Green bonds are “use of proceed” bonds and are not secured against any assets. Bond holders are effectively exposed to the same credit risk like holders of a conventional bond of the respective issuer. While increased demand may potentially lead to some price premium in the short term, the expected larger supply may ultimately equalise this.

Funding sustainable projects has its place in the bonds world

Green, social and sustainability bonds are a proven way to fund specific environmental or social projects. Sovereign and supranational aid will likely continue to focus on dedicated projects and the respective funding. However, time will tell if investors accept that a company can “earmark” a specific “green” or “sustainable” capex investment while its company strategy does not achieve high ESG standards.

Broader ESG consideration likely to gain in importance

An increasing number of investors are taking a responsible investment approach to successfully identify higher-quality bonds. In part, this includes using non-financial data or scores on the environmental, social and governance (ESG) practices of the issuers to inform their investment decision-making. The negative correlation between credit spreads and ESG scores seems to support this trend.

Investors can use a variety of ESG related bond indices, like the Bloomberg Barclays MSCI ESG Sustainability Index. These indices are designed to positively screen issuers from existing Bloomberg Barclays Fixed Income Indexes based on MSCI ESG Ratings, which are an assessment of how well an issuer manages ESG risks relative to its industry peer group.

Type of bond Feature
General All bonds are conventional bonds which are priced and traded in the same way as any other comparable conventional bond.
Green and social bond At least 95% of the proceeds must be earmarked for environmental (green bonds) projects, or social (social bonds) projects which is often tracked by ongoing reporting by the issuer. The bondholder is exposed to the credit risk of the issuer and has no prioritised pledge over any assets.
Sustainability bond Bonds where the proceeds are exclusively applied to finance or refinance a combination of green and social projects.
Sustainability linked bonds or ESG linked bonds

General corporate purpose issuance that incentivises a borrowers’ commitment to sustainability with coupon or interest rate tied to key performance indicator(s) (KPI) or face a punitive jump in interest payments (eg +25 basis points).

These indicators could be tied to;

  1. achieving a specific ESG rating, or
  2. sustainability-related KPI (eg percentage of company’s clean energy used), or meeting targets for one or multiple of the UN’s seventeen SDGs.
Sustainable development goal (SDG) linked bonds Bonds where the issuer has pledged to meet targets for one or many of the UN’s seventeen sustainable development goals or face a punitive jump in interest payments.

Market Perspectives June 2020

Financial markets have bounced further from March’s sell-off as more countries ease COVID-19 restrictions. But risks of another bout of COVID-19 infections and geopolitical tensions remain.


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