A heavy issuance calendar may keep volatility in bond markets elevated, but an expanded opportunity set should ultimately cement the role of green bonds in a multi-asset portfolio

To say that bond markets have had a volatile year would be somewhat of an understatement. Against a backdrop of inflation at multi-decade highs, the extremely aggressive central bank hiking cycle has left few places to hide across the fixed income spectrum. With cracks in the growth outlook across Europe now starting to emerge, we may well be closer to the end of this hiking cycle than the beginning. Yet while a pause to rate hikes in 2023 would certainly be cheered by many parts of the market, government bond investors will still need to adjust to supply and demand dynamics that look very different versus history.

Ballooning borrowing

Increased debt issuance lies ahead, with governments across Europe announcing significant spending plans to help soften the impact of the energy crisis. Germany committed to big spending in late September with a EUR 200bn energy package. France’s suite of energy measures is expected to contribute to a record EUR 270bn increase in public debt next year, while in Italy, new PM Giorgia Meloni is also eyeing up an increase in borrowing. The UK’s Energy Price Guarantee scheme may now be scaled back from April 2023, but the support plans will nonetheless necessitate tens of millions of pounds of borrowing.

Equally important for fixed income markets is the demand side of the equation. Support within the Governing Council at the European Central Bank to begin shrinking the balance sheet appears to be growing. In the UK, when issuance last surged during the early stages of the pandemic, the Bank of England was on hand to hoover up GBP 290bn of UK Gilts. Now, the Bank’s current plans see it shrinking its government bond holdings by a total of GBP 80bn over the next year.

The big issue

Against this backdrop of surging bond supply and diminishing demand, governments will be forced to think hard about their issuance strategy. Green bond markets are likely to be an area of particular focus. Of course, not all government spending can be financed by green bonds – they can only be issued in order to raise finance to tackle environmental challenges. Yet, with Russia’s invasion of Ukraine providing a fresh incentive for European governments to accelerate the energy transition and improve energy security, there is no shortage of projects that could be financed via this new avenue.

For governments, there are obvious advantages to this approach. The first is strong demand: green government bond issuance has been very well absorbed by the market over the past two years, with demand for allocations typically several times higher than the available issuance and often stronger than the demand for conventional bonds. The second benefit is the investor base: green bond syndications have typically seen larger demand from investors such as pension funds and insurance companies – and therefore more stable lenders of capital – than conventional syndications, where investors with shorter time horizons tend to play more of a role. Third is pricing: green bonds tend to trade with a green premium – or “greenium” – to traditional counterparts, both in sovereign and corporate markets, allowing issuers to fund green projects at a marginally lower cost of capital.

For investors, the prospect of large amounts of incoming supply is rarely something to cheer, yet this overlooks the fact that this issuance should go a long way to addressing one of the green bond market’s key deficiencies. While the UK and several nations across the continent, including Germany, have declared their intentions to build a green yield curve, the current offering of green sovereign bonds falls well short of this goal. Most European issuers have only a handful of outstanding bonds today, with the UK government’s most recent green issuance only its third foray into the space. In the supranational sector, the European Union is poised to become one of the world’s largest green issuers in the coming years, to finance the Recovery Fund, but also still only has three green bonds currently on offer, ranging in maturity from 2037 to 2048. As the green bond market matures, an expanded opportunity set that offers greater flexibility for investors is going to be a key requirement.

While there may be benefits for both issuers and investors from increased supply, an element of caution remains warranted. As ever when it comes to investing in green, social, or sustainable bonds, scrutiny at a security level will be key to success. Can the issuer demonstrate a clear link between bond proceeds and the intended project? Do the bond covenants contain measurable and specific targets for success? And will the bond materially change the position of an issuer relative to where they already stand? Only those bonds that meet these criteria will warrant a place in a green bond investor’s portfolio.

For Professional Clients/ Qualified Investors only – not for Retail use or distribution.

All data is as of 31 October 2022. The Market Insights programme provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the programme explores the implications of current economic data and changing market conditions.] For the purposes of MiFID II, the JPM Market Insights and Portfolio Insights programmes are marketing communications and are not in scope for any MiFID II / MiFIR requirements specifically related to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes, as non-independent research, have not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor are they subject to any prohibition on dealing ahead of the dissemination of investment research. This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. To the extent permitted by applicable law, we may record telephone calls and monitor electronic communications to comply with our legal and regulatory obligations and internal policies. Personal data will be collected, stored and processed by J.P. Morgan Asset Management in accordance with our EMEA Privacy Policy www.jpmorgan.com/emea-privacy-policy. This communication is issued in Europe (excluding UK) by JPMorgan Asset Management (Europe) S.à r.l., 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S. Luxembourg B27900, corporate capital EUR 10.000.000. This communication is issued in the UK by JPMorgan Asset Management (UK) Limited, which is authorised and regulated by the Financial Conduct Authority. Registered in England No. 01161446. Registered address: 25 Bank Street, Canary Wharf, London E14 5JP.

09dc222810093951