Sustainable bonds: a year of regulatory growth?

We highlight some trends that we believe will influence the sustainable fixed-income market in 2022.

Key points

• Fixed-income markets will play a key role in funding the journey towards a better environmental and social future, as the majority of funding is likely to come from debt rather than equity.
• We expect to see continued growth in ESG-labelled bond issuance with 2021 having set new records, albeit from a relatively low base in the context of the overall size of the global bond market today.
• One standout flaw that must be addressed is the lack of penalties for not delivering on intentions set out within green and social-bond issues.
• We think that if green and social-bond structures contained some of the same covenant tests as the newer sustainability-linked bonds, the risk of greenwashing would be lower.
• We think issuers will increasingly come under investor pressure to demonstrate their ESG strategy credentials.

Over the last 12 months we have seen a giant leap forward in environmental, social and governance (ESG) milestones, driven in part by the health and economic crisis induced by the global pandemic.

The role fixed-income markets have in funding the journey towards a better environmental and social future is crucial, as the majority of funding required is expected to come from debt rather than via equity. This is very much a ‘journey’, as a large range of stakeholders will take time not only to agree on the roadmap and how best to achieve it in our lifetime, but also on how to put their plans into action.

Regulation, regulation, regulation…

Regulators have continued to work hard on developing sustainable rules and taxonomies, and, in our view, are the single biggest driver of shaping the sustainability journey. As policy evolves, there is a need for the development of local regulations to keep pace by implementing minimum standards and encouraging the expansion of ESG products to finance the transition.

There is work underway globally on a number of taxonomies, with Europe continuing to lead the charge, but certain sectors of sustainable fixed income are yet to be covered in the European Union (EU) taxonomy, along with lower impact activities.

This year we may see the formal adoption of the EU’s Complementary Delegated Act, which means that the EU taxonomy will include specific nuclear and gas-energy operations within the list of economic activities covered.  We may also see the adoption of the EU Green Bond Standard, which comprises rules set up to explain how issuers can use green bonds to finance ambitious investments, while simultaneously meeting tough sustainability requirements and minimum standards to protect investors and reduce the risk of greenwashing.

In the US, it appears that the current focus is on improving disclosure rather than new ESG legislation, but even that has the potential to drive a significant shift in mindset and activity towards more sustainable objectives, certainly by the private sector.

The COP26 announcement of the creation of the International Sustainability Standards Board (ISSB) was particularly noteworthy. The standards will provide the foundation for consistent global ESG reporting standards (IFRS Sustainability Disclosure Standards) that will enable companies to report on ESG factors affecting their business. The expectation is that the ISSB will carry out a thorough public consultation in 2022, to give all stakeholders across the world an opportunity to provide feedback. This includes the consideration of work involving both thematic and industry-based requirements.

Further details on the EU’s social taxonomy should be expected in 2022, but we believe it may take some time to agree, given the varying social constructs of different regions and countries, which means authorities may have diverse priorities.

Labelled-bond issuance and management incentives

We expect to see a continued growth in ESG-labelled bond issuance after 2021 set new records, albeit the $1.6 trillion (per ICE Green, Social & Sustainable Bond Index) is still a small amount in the context of the overall size of the global bond market today. Labelled bonds are also often an area of the market that creates much debate and receives much commentary.

In 2021, US investment grade bonds saw significant issuance of $97bn versus European investment-grade issuance of €136bn. In high-yield bonds, the US and Europe saw $16bn and $28bn of issuance respectively, from close to zero in the previous year. However, what is notable is that in the high-yield area this represented 15% and 9% respectively of total bond supply.

As central banks start to tighten monetary policy, and in some cases talk of reversing quantitative easing (QE), the reduced amount of fiscal stimulus means that some of the emergency-induced bond supply is unlikely to reoccur. This issuance has acted as an extra catalyst for growth in labelled bonds, often driven by governments and agencies. That said, we still expect governments to be the largest issuers of labelled bonds globally.

We expect to see a continued broadening out of sectors as issuance is still quite concentrated in the finance, utility and real-estate sectors.

There is a risk that fragmentation and tiering begin to appear in some labelled bonds, such as new-format green bonds for example, with environmental targets within some sustainability-linked bonds starting to reference science-based targets. Our view is that the market needs a clear framework with consistent standards across regions of the world, which would help investors to compare and contrast issuers and bonds and better hold them to account. New labels may also be developed, but we believe that this could run the danger of creating ‘label fatigue’ and increasing the risk of greenwashing.

A just energy transition

The investment community is beginning to recognise the importance of focusing on social challenges, especially in the aftermath of the global pandemic. Environmental and social factors should not always be separated, given the importance of the idea of a ‘just’ transition. We must remember there are also social consequences to funding the climate transition, such as the change in profile of workforce skills required and the robustness of ethics within new supply chains, i.e., ensuring that the environmental focus does not cause any significant harm to any social factors.

This concept therefore lends itself to sustainability-linked bonds which incorporate a broader range of key performance indicators (KPIs), and include social targets that the issuer should also be held accountable for.

Sustainability-linked bonds contain covenants, which create penalties for the issuer if they do not meet set targets within a determined timeframe. The severity of the penalties continues to be debated, and some issuers have tried to establish loopholes at the outset. We hope to see greater consistency around bond documentation and robust incentives for management teams to deliver on credible and stretching targets, both because they recognise the importance of being responsible citizens, and because the penalties are material enough to encourage a behavioural change.

Standout flaw

Whereas some green and social-bond issuers are to be commended for having a genuine focus on improving environmental and social outcomes, there exists a standout flaw. There is no penalty for not delivering on intentions set out within green and social-bond issues. We think that if these bond structures contained some of the same covenant tests as the newer sustainability-linked bonds, the risk of greenwashing would be lower. We have often heard a representative of company management, for example, comment on how the main driver for issuing a labelled bond is to attain a lower cost of funding owing to the ‘halo effect’ of being considered a responsible corporate citizen.

There is the risk that a slight premium that can exist for green bonds today could potentially limit the growth of the market, but the demand for green products continues to grow. Over the next few years, we think there will be less need for bond issuance to be in labelled-bond form. The increasing accountability of all stakeholders, including governments, companies, investors and asset owners, should mean less need for labels but more emphasis on differences in the cost of capital between issuers.

We cannot rely on the sheer size of climate spending required being absorbed by the labelled bond market but, with greater accountability from many stakeholders, we believe it doesn’t need to be.

Progressive bondholder engagement

Having been engaging with bond issuers for some time now, we are still often surprised by peers’ lack of questioning of management teams around ESG topics. However, we do sense that issuers are becoming more cognisant of the higher expectations placed on them and the need to demonstrate the efficacy of their ESG strategy.

From an environmental perspective, we think that issuers will be under more pressure not only to have an emission-reduction strategy, but also to begin to report alignment with the Science-Based Target Initiative. From a broader ESG perspective, we think issuers will increasingly need to demonstrate their ESG strategy, as well as considering assets at risk and mitigation strategies over the longer term. We believe investors will also follow up with increasingly informed testing of management teams and governments on sustainability issues.

Bond and equity cooperation still at nascent stage

We still do not see much progress from an industry-wide perspective in terms of credit and equity investors working together on ESG issues. However, this is something that we believe will increase the level of accountability faced by issuers, resulting in a more resilient and effective business model and governance structure, and, ultimately, improved societal and environmental outcomes.

Authors

Scott Freedman

Credit analyst & portfolio manager, Fixed Income team