Bond market refresh

The market for green bonds is bursting in response to growing investor appetite for ESG exposure. Meeting that demand amidst such a relatively small universe of qualifying bonds sometimes requires ingenuity and an open mind.

“The asset management industry over the last 12 to 18 months has pushed itself to get there, as we have seen the investor demand rise, and usually it’s the other way around, where the asset managers are pushing investments,” said Vishal Khanduja, director of investment grade fixed income and trading at Eaton Vance, where he manages nearly $8 billion worth of ESG bond portfolios through the Calvert Investments subsidiary.

In many respects, the fixed-income market is well ahead of and much better suited for ESG investing than are the equity markets where most of the ESG investing has been concentrated so far.

While financial advisers might generally associate sustainable and green investing with equity markets and funds, the bond market, representing a much smaller environmental, social and governance investing footprint, characterizes a tidier look at the space and its potential.

It boils down to the structured nature of debt versus equity ownership. In other words, because debt issuance is essentially applying for a loan from potential investors, the debt issuer, or borrower, is immediately and directly motivated toward conformity in ways that are more difficult to duplicate in public equity markets.

“On the fixed-income side, the self-policing is a little stronger and the green bond mechanism gives us a way to do that because it’s about raising new debt,” said Cheryl Smith, economist and portfolio manager at Trillium Asset Management.

Unlike the equities space, where ESG definitions continue to evolve and potentially confuse investors, the bond market has an almost mathematical process for qualification as ESG. Basically, an issuer offering a green bond is required to clearly state the use of the proceeds, have an ongoing evaluation process, formal management of the proceeds and standardized reporting.

Even if that blueprint is not strictly followed, the very structure of debt issuance, including preset yields, duration, and expiration, make it much easier to monitor and measure the ESG connection and impact.

“With debt issuance you have leverage over the issuer,” Smith said. “The fixed-income market is so much bigger in terms of dollars that if you don’t like an issue you can just wait for the next one.”

ROBUST FORECAST

At more than $50 trillion, the global bond market is about three times the size of the global equity market, but it has only recently started to gain real traction in the ESG space.

Through mid-September, global ESG bond issuance surpassed $140 billion, and it is expected to reach $350 billion by year’s end, according to Climate Bonds Initiative. If the forecasts are accurate, 2020 issuance will represent a 36% increase over 2019, which saw $257 billion worth of ESG bonds issued.

The forecast is so robust for the remainder of the year because companies have been “issuing at a furious pace” over the past several weeks, Smith said. 

For example, during the first two weeks of September, the data show $11.8 billion worth of green bond issuance, compared to $13.3 billion for all of August. 

Vanguard, the nation’s largest fund manager, last week entered the ESG fixed-income market with the launch of a fixed-income ESG exchange-traded fund for investors.

Calvert, like a lot of asset managers scrambling to meet growing demand for green bonds, goes beyond just that smallish universe of debt labeled ESG to include debt from issuers that qualify as ESG-focused.

“We look at the issuer profiles and the way we define a green bond also includes climate-aligned issuers that are not stamping their bonds as green,” Khanduja said.

For example, a company like Tesla. As a maker of electric cars, Tesla is generally regarded as an ESG-friendly company, but only two of its three debt offerings were stamped as green. Fixed-income managers seeking ESG bonds for their portfolios might not have a problem buying Tesla debt that is not officially labeled as green.

“The challenge with green bonds is the limitations in what’s available in the market at any given time,” said Emily Lawrence, director of sustainable investing for the institutional product group at Northern Trust Asset Management.

“I don’t think an issuance needs a green bond designation to be considered sustainable, if we do that, we’ll end up seeing issues related to the potential to create a diversified portfolio,” she added. “Not all issuers are inclined to go through with the whole [green] certification process.”

Some might argue that the practice of building green bond portfolios from debt issued by green companies is a form of “greenwashing,” where companies or funds attach the ESG label without qualifying as ESG. But even the Climate Bonds Initiative recognizes bonds that are not certified as green.

GREENWASHING

In fact, of the $140.5 billion worth of issuance tracked by CBI so far this year, just $31.5 billion is certified, while the remaining $109 billion is described as labeled green and aligned with CBI definitions. To illustrate the scrutiny and the potential for misleading greenwashing, CBI also shows an additional $102.8 billion worth of debt issuance this year that is labeled green — but is not aligned with CBI definitions.

“When green bonds first came out, companies were just slapping on green labels and there wasn’t a lot of follow-through, but it has gotten more strict,” said Jennifer Tonda, director of institutional trading with a focus on green bonds at 280 CapMarkets.

“It’s definitely harder to greenwash in the bond space,” she said.

While many ESG investing purists have historically downplayed the issue of investment performance as a secondary benefit of doing good, the ESG category’s steady migration into the mainstream makes performance an issue that can no longer be pushed aside.

Tonda said the smaller universe, combined with the fact that a lot of ESG investors will buy and hold the bonds to maturity, can reduce liquidity of some green bonds.

“Some of these deals are smaller so the liquidity isn’t so great,” she said. “You can usually pick up some yield on the secondary market.”

Most portfolio managers will reference the fact that the yield is pegged to the issuer, which tamps down any unique characteristics of the green factor of the bond. Calvert, for example, makes that point clear by measuring the performance of its green bond funds to traditional fixed-income benchmarks.

“We’ve not seen investors giving up anything in terms of yield,” said Calvert’s Khanduja. “If you’re doing your job correctly, you should be able to beat broad benchmarks.”

PAYING A 'GREENIUM'

The flip side of the growing appeal, however, is that as with any commodity, the demand for the uniquely green characteristics could eventually impact investors.

“There’s definitely the question of whether an issuer can sell its bonds at a higher price with a green label,” said Dan Workman, bond fund manager at Franklin Templeton. “In theory, you could command a stronger audience for a green bond relative to other debt, but we don’t see that in the market now.”

The idea of paying more, or giving up yield, to invest in a green bond, sometimes referred to as paying a “greenium,” is something that green bond buyers might eventually face, Workman said.

“For the investor it could be a worse deal to buy a green bond, and that’s a very interesting dynamic that folks are really focused on,” he said. “It’s not clear if there are investors willing to pay a premium to own a green bond. That would be someone consciously saying this [specific investment] has value and that they are willing to pay for that.”