In brief
- Accelerated issuance in social and sustainability bonds is creating a more balanced opportunity set within the use of proceeds bond market.
- Issuance in Europe far outstrips other regions, but Asian issuance is on the rise. A lack of “Green Treasuries” results in a lower US weight relative to traditional bond markets.
- GSS bond and traditional bond index returns have been highly correlated over recent years, although GSS bond indices are more influenced by moves in credit spreads.
- It is possible to build diversified GSS bond portfolios with a similar risk profile to traditional global bond indices.
Many investors continue to focus attention on financial instruments which, alongside producing an investment return, also aim to aid progress towards a more sustainable and inclusive economy. Green, Social, and Sustainability (GSS) bonds have emerged as a mechanism for directing capital towards projects which address critical global issues such as climate change, biodiversity, social advancement and sustainable economic growth. These "use of proceeds" bonds are designed to fund specific projects with clear environmental or social benefits, thereby aligning the interests of investors with broader sustainable goals.
The GSS market is maturing into a large and well- diversified segment, offering bond investors the opportunity to better align portfolios with their sustainable objectives. In this piece, we will argue that GSS bond investing no longer requires investors to take undue concentration risk, and that a diversified GSS bond portfolio can behave much like the rest of the high-quality fixed income market.
An illustrious career: the GSS journey so far
In 2012, with the world’s attention captured by the London Olympics, the GSS bond market was just getting warmed up. A fledgling competitor versus the wider bond market, issuance amounted to only USD 5.2 billion dollars that year, according to data from LSEG Eikon. But by 2021, as the world’s athletes came out of lockdown and descended on Tokyo, the GSS bond market was sprinting to record levels of issuance: USD 1.2 trillion. In 2024, back at the scene of the Paris accords, this market has become more akin to a marathon runner, in for the long haul and with steady annual issuance dynamics: almost USD 400 billion so far this year and USD 900 billion on average over the previous two years.
Until the end of 2019, the use of proceeds market was dominated by the growth of green bond issuance. This dominance was largely driven by a broader awareness of environmental challenges, regulatory and policy changes, and increased demands on investment managers to explicitly consider environmental issues in investment decision making. Since 2020, green issuance has continued but has been joined by an increase in social and sustainable bond issuance, with Covid-19 helping to bring social issues into sharper focus.
The net effect is a bigger and more varied market. Today, the GSS bond market stands at USD 4.1 trillion, with 38% of that in social and sustainability bonds. Also noteworthy is the onset of sustainability-linked bonds (with more than USD 800 billion outstanding), a different proposition which do not require proceeds to be explicitly directed to certain projects.
A note on sustainability-linked bonds
Sustainability-linked bonds 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. These types of bonds have proven particularly popular in the high yield market.
There are key challenges in this 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 are insufficient. Therefore, as with use of proceeds bonds, active management and heightened scrutiny is key.
What makes up the GSS market?
As the GSS market is growing and becoming more varied by the type of bond label, diversification is also emerging in the regional and sector make-up of the market.
Europe still dominates geographically, reflecting the ongoing demand for sustainable investment solutions across the region and the evolving regulatory backdrop. Asia is the second largest issuer of GSS bonds, with 23% of issuance year to date and 31% over the previous two years. This likely results from a combination of corporate capital expenditure and sustainability commitments, supportive government policy, and the development of regulation and green taxonomies across certain countries in the region. Financial institutions are the biggest issuers of Asian green bonds, consistent with global corporate issuance dynamics.
The US represents only 13% of debt outstanding, and there’s little sign of change: on average, the US has accounted for 13% of the last five years’ GSS bond issuance. Green US Treasury bonds are particularly notable by their absence. An entry into the GSS market by the US government was mooted earlier in the year and, should it occur, the GSS market would more closely resemble the broader global aggregate bond market.
From an issuer perspective, the heterogeneous nature of fixed income markets is becoming better reflected in the use of proceeds universe. Of all GSS debt outstanding today, half is now issued by corporates, with the rest broadly split across government, municipal, agency, multi-lateral and supranational issuers. There is still a significantly higher concentration in corporates compared to the Bloomberg Global Aggregate Bond Index (where corporates make up a fifth of the index) but the arrival on the scene of social and sustainability bonds has altered the universe’s composition. If we were to examine just the green bond market, corporates would make up almost two thirds of debt outstanding.
Sector-wise, financial issuers are the most prolific, consistent with non-GSS corporate markets, driven by substantial regulatory funding requirements. Banks are using GSS bonds to fund sustainable lending, financing the green and social segments of their loan books which are experiencing significant growth.
Electric utilities, perhaps unsurprisingly, are also prominent issuers, given their direct business involvement in power generation drawn from fossil fuels. The sector is seeing a strong move to decarbonisation, and green bonds are being used to finance renewable energy and energy efficiency related projects. Some utilities are also investing in green buildings and clean transportation, using green bonds as a source of capital.
how bond proceeds are being used for that title?
Industry bodies such as the International Capital Market Association or the Climate Bonds Initiative have published frameworks to highlight best practice and encourage issuers to build robust issuance frameworks. Investors must note, however, that these frameworks are voluntary and largely unregulated, leaving passive investors exposed to the ever-present risk of “greenwashing” that is often associated with labelled bond issuance. We believe that an active, research-driven process – with ongoing assessment of post-issuance allocation reporting – is therefore vital to ensure that issuers are providing sufficient transparency on the deployment of investor capital.
Does GSS bond investing come at a cost?
By now, the concept of a ‘greenium’ is well-understood by investors. Because GSS bonds can offer transparency around the use of capital and a clear link to sustainable objectives,1 there can sometimes be increased demand for such instruments, resulting in a premium (a lower yield) vs. general purpose bonds from the same issuer. The presence and extent of a greenium varies by sector and issuer. While sometimes it doesn’t exist at all, it’s also not unusual to see a 5-10 basis point yield give up on an individual bond basis. This has led to scepticism about the return prospects of a GSS portfolio – particularly in the previous regime of near-zero interest rates, where every basis point counted as a bigger proportion of all-in yield.
However fixed income portfolios, which are typically very well-diversified with a large number of individual bonds and issuers, can be considered from a top-down, as well as bottom-up, perspective. Here, there are some interesting dynamics at play.
In 2022, Bloomberg launched its Global Aggregate Green, Social & Sustainability Bond Index, reflecting the growth in this market and growing interest from investors. This index – with Global Aggregate in its name (unlike the earlier Bloomberg MSCI Green Bond Index) – reflects in several ways the core, high-quality characteristics of the broader Global Aggregate Index.
In terms of headline risk profile, the duration and quality of the GSS and the Global Aggregate Indices are broadly similar. Clearly, there are fewer issuers in the GSS index, but more than 2,600 makes concentration risk a lesser concern.
Perhaps most notable is the GSS index offers a slightly higher yield than the broader Global Agg (4.9% vs 4.7%, hedged to USD). This will come as a surprise to investors focused on avoiding a greenium. It can be explained by the underlying sector composition in the two markets: as we’ve discussed, there are no green US Treasuries, which are a significant portion of the Global Agg. There are also no green Japanese Government Bonds (yet), which would serve as a drag on yield. Accordingly, there is more exposure to spread sectors within the GSS universe. The option-adjusted spread of the index is 69 basis points, compared to the Global Agg’s 38 (data as of 31 July 2024).
Thus, while a greenium effect may mean that individual underlying bonds in the GSS universe yield slightly less than their traditional counterparts in the Global Agg, this is offset by the sector and issuer composition resulting in a marginally higher all-in yield.
What does this mean for returns? It’s challenging to get a long-term look back on realised performance of a GSS index vs a ‘traditional’ index, because of the changing issuance landscape over the years and the nascence of the GSS market. With that caveat acknowledged, there is a very high correlation of returns between the two indices since the launch of the GSS Agg (0.98 based on monthly return data since the end of 2022). Directionally, total returns have tracked closely with one another, albeit with some divergence due to the relative credit overweight in the GSS market in a period of tightening spreads and stable rates.
With all else equal, this could reverse in a risk-off, contractionary scenario where credit spreads widen and core rates fall. Nevertheless, a high correlation over time with the Global Agg, combined with increasing size and liquidity, suggests that investors can regard the GSS market as a suitable core holding in a fixed income portfolio.