In brief
- The green, social and sustainability (GSS) bond market has been growing rapidly, and such bonds offer investors transparency and alignment with environmental, social, and corporate governance (ESG) goals
- Fixed income has undergone a remarkable repricing, and the period of extraordinarily low interest rates appears to be over. Therefore, fixed income once again offers income and diversification potential
- The aggregate GSS market out-yields the broader global aggregate market – which means the “greenium” associated with use-of- proceeds bonds need not be a significant concern.
- Active management is crucial within this market; labelled bonds carry a heightened risk of greenwashing, and investors should consider each bond’s sustainable issuance framework as well as the issuer’s creditworthiness.
Introduction
J.P. Morgan Asset Management’s 2023 Long-Term Capital Market Assumptions (LTCMA) highlighted the potential for introducing fixed income back into portfolios following the broad-based repricing of the bond market over the past two years. At the same time, investors continue to look to investment managers to help them reach their climate goals. They are looking for innovative ways to measure the output and the impact of their investments, while accessing compelling investment opportunities.
Here, we explain why the growing green, social and sustainability (GSS) bond market represents a significant untapped opportunity; this liquid, diversified and income-generating asset class can offer heightened transparency and full alignment with sustainable goals.
The green, social and sustainability bond market has been growing
Trillions of pounds1 will be needed in the coming decades to combat the world’s climate problem. Companies and governments are waking up to the scale of the challenge, as is the investor community. Until recently, the focus of investors has largely been on reducing portfolio emissions and tackling the energy transition: at least 315 investment firms – representing USD 64 trillion in assets under management – are now signatories to the Net Zero Asset Managers Initiative2. Debt capital markets have a key role to play here, with green financing – through the issuance of green bonds – an important lever to pull. It’s not all about net zero, either: there is a pressing need to avoid pollution and biodiversity loss, and to ensure our water supply is managed appropriately. The proceeds from green bonds can address these issues.
Beyond the environmental challenges we face, key social issues have gained prominence: inequality, lack of access to basic infrastructure and rising living costs have led a broad range of stakeholders to initiate tangible social change, funded via the debt markets. Companies, governments, foundations and multilateral institutions are issuing social and sustainability bonds to fund community development and to facilitate access to essential services.
The green bond market (consisting of debt instruments issued specifically to fund environmentally beneficial projects) has become a big opportunity set. In 2017, green bond issuance amounted to USD 163 billion. In 2021 – a record year for green issuance – the market digested over 675 billion dollars of issuance. By now, there is around USD 2.5 trillion of green debt outstanding. So this is a big enough market to facilitate a core allocation portfolio, and provides enough size to conduct an active process within it, since greenwashing remains a risk.
Social bonds (where the use of proceeds explicitly fund socially beneficial projects) and sustainability bonds (which fund a mix of green and social projects) have developed more recently. Covid-19 appears to have acted as an accelerant for such issuance: social issuance grew ninefold in 2020 to USD 180 billion, with sustainability bond issuance more than doubling to USD 176 billion. Taken together, Green, Social and Sustanaibility (GSS) debt now stands at around USD 3.9 trillion.
As the opportunity set has broadened from green bonds to include social and sustainability bonds, the market has become more diversified, particularly by issuer type. Exhibit 2 shows the issuer breakdown of the GSS bond market. Looking only at green bonds, the private sector dominates the landscape by quite some margin (accounting for 65% of green bonds outstanding). The addition of social and sustainability bonds means that multilateral issuers (such as the European Union) and sub-sovereigns (such as local government bodies) have become a larger part of the market.
Investors are actively seeking ways to participate in the drive for a more sustainable and inclusive economy. And the benefits of holding ‘use-of-proceeds’ bonds are clear: full transparency is available on the use of capital, with various international frameworks in place to guide reporting and disclosure by GSS issuers. Foremost here are the GSS bond principles laid forth by the International Capital Markets Association, which act as a handrail encouraging clear alignment to sustainable projects and a full commitment to regular impact reporting by issuers.
Bonds can finally do their job, and GSS bonds are no exception
We are now firmly in a different yield regime. Going into 2022, the Global Aggregate Bond Index offered a yield of 1.3%, but this low yield dynamic is a thing of the past and the Global Agg now yields 3.9%. With central banks likely at or near the peak of the cycle, the window is open to add fixed income. Bonds are again able to do what they were always meant to do: provide income and offer diversification in the event of a sharp downturn.
For investors looking for transparency when it comes to sustainability, the GSS universe can play a key role as a core fixed income holding. GSS bonds are still, after all, bonds. In 2022, Bloomberg launched the Global Aggregate Green Social & Sustainability Bond Index. This index exhibits core-like characteristics, as shown in the table below. GSS bonds tend to be high quality, with a long duration profile, although active management can allow investors to mitigate this risk according to preference, while retaining some of the GSS market’s key characteristics.
The GSS market thus provides high-quality exposure at a historically attractive price, while also offering a clear link between bonds’ proceeds and explicitly sustainable projects.
What about greenium?
Strong demand for GSS instruments can lead to the ‘greenium’, whereby green bonds trade at a premium to their ‘non-green’ counterparts – resulting in a lower yield. While the greenium isn’t universal,3 it can nevertheless exist at the individual security level, potentially leading to hesitancy from investors unwilling to give up yield to achieve sustainability goals. But there are a few key reasons why the greenium isn’t necessarily the drawback it once was:
- It is a function of demand, which can be viewed as a strong technical factor when determining whether an investment will perform well. Active investors may benefit from increased demand at issue, which can lead to further spread tightening in the secondary market.
- The greenium is less painful now, as a proportion of the all-in yield, than it used to be, when yields were much lower.
- The growth in GSS issuance means that there are more opportunities in extended sectors such as high yield and emerging market debt. Active managers can branch out into these sectors to mitigate some of the premium paid on high quality, investment grade GSS bonds.
Perhaps most importantly, though, is that despite some individual bonds carrying a premium vs their non-GSS counterparts, the GSS market has a structurally higher yield than the Global Agg – even with its higher credit quality. This is counterintuitive, but it reflects issuance dynamics.
Government bond exposure differs, for instance, 11% of the Global Agg is in lower-yielding Japan, the vast majority being government bonds. Despite a plan to issue USD 150bn+ in green bonds over the next decade, Japanese Government Bonds (JGBs) don’t feature at all in the GSS index. Japan exposure is 1% in total. This alone results in a yield difference of ~7 basis points in favour of GSS. Additionally, with the absence of key government bonds in the GSS index (there are also no GSS Treasury bonds), there is a structural difference in credit spread: the Option-adjusted Spread on the GSS index is 89 basis points, which is 49 basis points higher than the Global Agg4.
Active management is still critical
As attractive as the overall investment opportunity is, investors must be mindful of greenwashing. Established international principles – such as those set forth by the International Capital Markets Association –can help issuers and investors to establish best practice for use-of-proceeds bonds. ICMA’s Green, Social and Sustainability Bond Principles guide issuers on how they should select projects to be financed, as well as setting standards for post-issuance compliance and reporting. Beyond these frameworks, issuers will typically seek a second-party review of their issuance terms, typically from specialist research and data providers, to add a layer of assurance for investors.
However, while these are legitimate and widely used handrails, adherence to them varies. This increases the risk of greenwashing. This is why active management is particularly important in the GSS market: it may be tempting to take the word of a second-party opinion or an index provider, or to take the label at face value, but investors should apply heightened due diligence in their own investment process to be confident that such bonds are being issued in good faith. Here is our approach.
In conclusion
The time to consider adding fixed income back into a portfolio is now, given historically attractive fixed income valuations. The Green, Social and Sustainability bond markets have been steadily growing in the past few years and now represent a multi-trillion dollar opportunity set. Such bonds offer high-quality, core exposure, and currently out-yield the global aggregate bond market. But they also offer a clear link between investor capital and sustainable projects. With active management, there is a compelling opportunity here to generate alpha and align portfolios with clear environmentally and socially beneficial projects.
A note on sustainability-linked bonds
An interesting – and more recent – development is the growth in the sustainability-linked bond market. These bonds – popular in the high yield market – are different from ‘use of proceeds’ bonds in that capital can be used for any purpose. Instead of financing sustainable projects, the issuer will be required to meet certain sustainability targets – reducing carbon emissions, for example. If they fail to meet these targets, a penalty – typically a step-up in the coupon paid on the bond – may be applied, or the issuer might be rewarded with a lower coupon for successfully meeting targets.
There are key challenges in this relatively nascent market: some sustainability-linked bonds might look sustainable on the face of it, but in some cases the issuer’s targets might not be very ambitious, and the magnitude and timing of penalties is insufficient. Therefore, as with use of proceeds bonds, active management and heightened scrutiny is key. Nevertheless, sustainability-linked bonds can be an interesting proposition, and their emergence reflects broadbased innovation in fixed income when it comes to sustainability.