Ethical investments have never been hotter. Assets under management in all investment strategies governed by environmental, social and governance (ESG) principles grew more last year than in the preceding decade.
Looking more closely at the fixed income and, more specifically, the corporate bond market, there has also been a significant acceleration in the growth of ESG-driven investment strategies, as fund flows into ESG-dedicated portfolios picked up pace.
While many will be familiar with the US$1 trillion ($1.28 trillion) green bonds market, issuance of other debt securities designed around ESG considerations has been gathering pace.
For example, new social bond issues totalled US$154 billion in 2020, up from US$18 billion in 2019. Sustainability bond issuance hit US$69 billion in 2020, from US$38 billion a year earlier. Sales of both instruments are on track to more than double this year, according to Institute of International Finance (IIF) data.
Much of this activity can be attributed to a combination of regulatory pressure, rising corporate awareness and investor demand. The popularity of this investment theme has also been boosted by growing awareness of the social problems that have worsened during the pandemic.
While we applaud the amazing speed of this growth, we’re also concerned. When markets move this far this quickly, inevitably some corners end up being cut. We see a risk that money will flow into investments whose ESG credentials don’t stand up to closer scrutiny.
One illustration of the frenzy that has built up around ESG can be seen in the world of emerging market corporate debt, where ESG-labelled bond issues rose to more than 21% of total issuance in the first quarter of this year.
Within this evolution of ESG-labelled bonds, we are seeing a new instrument gain popularity: sustainability-linked bonds (SLBs).
SLBs allow borrowers to set a sustainability target, while committing to pay a penalty if they fail to achieve that target.
Investors are attracted to them because issuers are tied to specific outcomes rather than a simple expenditure goal. This, in theory, more closely aligns the interests of borrowers with those of investors who want a clearer idea of the positive effects of their capital.
Bank of America expects global SLB issuance to reach US$100 billion in 2021. This is extraordinary considering the market for SLBs only started in 2019; US$10.9bn of SLB transactions were priced in 2020, according to the IIF. Growth is accelerating as issuance in the first quarter of 2021 almost matched the value of bonds issued last year.
Although this is global data, we’ve also seen SLB issuance grow with the same momentum in Asia. What’s more, European markets will likely be fertile ground given the region’s history at the forefront of developments in responsible investing.
WHAT’S THE PROBLEM?
Financial instruments that are marketed with an ESG label often come with a second-party opinion from a ESG ratings agency, such as Sustainalytics or Vigeo Eiris. This is to ensure alignment with a recognised framework – for SLBs this would be the International Capital Market Association’s SLB principles. This framework contains five components:
- Selection of key performance indicators (KPIs);
- Calibration of sustainability performance targets (SPTs);
- Bond characteristics;
- Reporting; and
The framework states that SPTs should be ‘ambitious’ and ‘beyond a business as usual trajectory’. It also requires that variation from original terms should be ‘meaningful’.
Unfortunately, these requirements are qualitative. So far, second-party opinion providers have been unable to establish requirements that are quantifiable. In particular, the issue of ‘meaningful’ variation has been problematic.
For example, all but one of the US dollar-denominated SLBs issued this year feature a penalty of less than 10% of the original coupon rate. Nearly half of these SLBs have a variation of less than 5% of the original coupon rate.
In several cases, the coupon variation, or step-up, only applies to the final year of the SLB’s life, making the present-value impact of the potential financial cost even less significant.
What’s more, there are other examples where the measurement of KPIs and financial costs coincide with times when the bonds are callable. This gives the issuer an option to redeem the bonds early and avoid paying a financial penalty.
A five-year bond from Asia with KPIs that only require the installation of certain assets at a total cost of US$1 million (from annual capital expenditure of up to US$200 million). The penalty for failing to meet this target is a 25 basis points-increase to the interest rate for 15 months prior to maturity – a period of time when the bonds are callable.
An 8.5-year bond from the US with a 12.5 basis points-coupon step-up if the issuer fails to achieve emissions-reduction targets. However, the step-up applies from the fifth year onwards – when the bond becomes callable at par.
A 10-year bond from Asia with a KPI based on achieving emissions reduction targets. While the coupon step-up is a meaningful 75 basis points, KPI assessment doesn’t take place until nine years after the bonds have been issued. That means the economic cost to the issuer for failing to meet the target would be immaterial.
WHAT SHOULD INVESTORS DO?
‘Greenwashing’ is when a company deliberately overstates green credentials. This is a risk in the SLB market where we see great diversity in the quality of bonds. That’s why the bottom-up assessment of issuers and the specific features of individual SLBs, is critical.
Investors need to be more discerning, not skimp on due diligence, and speak out whenever they find something that needs addressing. They need to ask themselves whether an issuer is undertaking substantive changes to transform its business. Is it benefiting from the retirement of aging assets to meet its KPIs? Are the costs of failing to meet SPTs significant, immaterial, or can they be avoided?
Investors can also push issuers to improve the quality of SLB issuance by demanding:
- That KPIs are assessed on multiple dates that span most, if not all, of a bond’s life;
- Greater use of milestones to track progress on meeting KPIs over time;
- Financial penalties that reflect a higher proportion of the original borrowing cost; and
- Call features don’t allow issuers to circumvent the costs of failing to meet KPIs.
Being a good ESG bond investor involves more than reading what’s written on the tin. There can be no substitute for the hard work that lies behind active investing.
Paul Lukaszewski is head of corporate debt – Asia Pacific at Aberdeen Standard Investments.