Sustainability bonds, good bonds

The signs of the time are green, pointing to sustainability – including in the case of investments. This also applies increasingly to bonds. Good for the environment and good for investors. And now, to recap.

Society is paying more and more attention to this issue, in light of the increase in freak weather events and the impact of climate change on nature, the environment and day-to-day life that can now be seen all over the world. Politically, too, a lot of changes are underway, reinforcing the trend toward greater sustainability. The Paris Agreement, for example, aims to limit the global increase in temperatures to 1.5 degrees Celsius. Or the UN Sustainable Development Goals, which among other things call for us to address the important social challenge of rebuilding the economy into one that acts in a more climatefriendly, environmentally acceptable and socially responsible way.

In December 2019, Europe launched the EU Green Deal in order to comply with this agreement. Its objective: to make Europe CO2 -neutral by 2050. To accomplish this, Europe intends to make energy generation and supply more climate-friendly. In other words, the energy revolution will come, and along with it the construction and expansion of renewable energy capacity, the shutdown of coalfired electricity generation, the decarbonisation of gas (“green gases”) and improvements in energy efficiency. In addition, there is a series of initiatives that provide further details and specifics about the issue, thereby pushing it forward.

Who, what, why?

PRI is one of the most important global initiatives for promoting responsible investing, with more than 3,800 signatories representing around USD 120 trillion in assets at the end of December 2021. Its goal is to promote better understanding of the impact of investment activities on environmental, social and corporate governance issues, and to help the signatories integrate this issue into their investment decisions.

TCFD stands for “Task Force on Climaterelated Financial Disclosure”. This initiative was founded in December 2015 by the Financial Stability Board, an international panel, to promote international financial stability, and to develop uniform standards for the disclosure of climate-related financial risks by companies, banks and investors to their stakeholders

Members of the Net Zero Asset Owner Alliance, which was set up by the United Nations in 2019, focus on climate-friendly investing, and undertake to make their investment portfolio climate-neutral by 2050. To date, 74 institutional investors have signed on to this initiative, including banks, insurance companies and pension funds. Together, they manage USD 10.6 trillion in assets.

The Net Zero Asset Managers Initiative, which was set up in December 2020, is an international group of asset managers that actively supports the goal of achieving a climate-neutral economy by 2050 or sooner in order to contribute to the goal of limiting global warming to no more than 1.5 degrees Celsius above the preindustrial level. Members have undertaken to reduce the greenhouse gas emissions of their investment portfolios to net zero by 2050 at the latest.

The overall thrust is therefore clear: sustainability factors should be taken into account when making decisions about investing and financing (sustainable finance). The goal is to reallocate capital flows into sustainable growth, and to control the financial risks connected with climate change, destruction of the environment and social problems.

Growth of the regulatory framework...

But regulations are also applying pressure in this direction. For example, as part of the EU’s Markets in Financial Instruments Directive II (MiFID II), since August 2022 asset managers and investment advisors have been required to ask their clients about their sustainability preferences. If the client wants to take ecological impacts into account in his/her investment, then it is necessary to determine the extent to which this must be integrated into the potential financial instruments used. There are three areas for which the client can define his/her preference. Taxonomy-aligned products offer a minimum proportion of investments in environmentally sustainable investments. “Sustainable investments”, in turn (based on the SFDR definition), have a minimum proportion of investments in sustainable investments. And the Principal Adverse Impacts (PAI) segment covers investments that consider primarily the most important negative impacts on sustainability factors. The sustainability preference may encompass individual aspects or a combination of all aspects. The respective minimum proportion of taxonomy-aligned and sustainable investments is determined by the client himself/herself.

As if that were not complicated enough, there are additional important new regulations relating to sustainable finance. These include the EU Taxonomy, the Corporate Sustainability Reporting Directive (CSRD) and the Sustainable Finance Disclosure Regulation (SFDR). The EU Taxonomy creates a common classification system for the EU economic area in order to define which activities are regarded as environmentally sustainable. The CSRD requires companies to publish sustainability information about their business activities. For example, greenhouse gas emissions (GGEs) must be disclosed in the Management Report. The SFDR, in turn, applies to financial market players such as insurance companies and fund management companies. The regulation stipulates that product providers must disclose to their clients the extent to which they include sustainability factors in the investment process for financial products, and how the principal adverse impacts on sustainability are taken into account.

Sustainability bonds: one idea, two approaches

Use-of-proceeds

Green and social bonds: proceeds are used exclusively to finance green or social projects that meet the criteria for funding. Examples of such projects include climate change, conservation of natural resources, the promotion of affordable housing and the active promotion of equal rights.

The International Capital Market Association (ICMA), an international industry association for capital market participants, has developed a voluntary global framework for sustainability bonds that provides comprehensive guidelines covering project screening, use of proceeds and reporting. One of the largest issuers of use-of-proceeds bonds is the European Union’s SURE Program (Support to Mitigate Unemployment Risks in an Emergency – measures to cushion against and reduce pandemic-related unemployment). European countries such as France and Germany are major issuers of green bonds.

Sustainability-linked bonds

Issuers wishing to implement company-wide sustainability goals can also use sustainabilitylinked bonds (SLBs). With SLBs, issuers undertake to achieve certain key performance indicators (KPIs) that contribute to sustainable management. One example would be reducing CO₂ emissions by a specific amount by a certain date. If the targets are not met, additional payments will be owed to the investor – usually a higher coupon. The International Capital Market Association (ICMA) has also drawn up principles for sustainability-linked bonds. The issuer undertakes to achieve pre-defined sustainability and ESG goals within a certain time frame.

A subgroup of sustainability-linked bonds includes securities from companies that have undertaken to achieve pre-defined decarbonisation rates in accordance with the Paris Agreement. For example, these companies can be identified through participation in the Science-Based Targets initiative (SBTi). As of July 2022, more than 1,600 companies have entered into verifiable commitments to significantly reduce CO2 – and more than 1,200 companies are pursuing a goal of climate neutrality.

Growth of the market…

In other words, the issue of sustainability is becoming an increasingly important aspect of investing. More often than not, investors are combining their financial and economic demands with sustainability goals. That also applies increasingly to bonds. For good reason.

These securities offer investors the opportunity to generate a positive contribution toward their own sustainability goals. Here, one can distinguish between two categories of bonds. One group includes use-of-proceeds bonds, where the bond proceeds are used for projects with positive measurable and sustainable impacts, such as the reduction of greenhouse gases or the expansion of capacity for generating power from renewable energy sources. The second group is sustainabilitylinked bonds. Here, the issuer undertakes to make its value chain significantly more climate-friendly and transparent by adopting certain performance criteria relating to its sustainability goals.

After the European Investment Bank (EIB) issued the first sustainable bond in 2007, it took more than a decade before investors' interest in this bond segment took root. But recently that has changed: whereas in 2018 the global volume of new sustainability bond issues totalled some USD 200 billion, this figure had already jumped to over USD 350 billion by 2019. In recent years, the pace of sustainability bond issues has accelerated even more, and in 2021 bonds with a nominal value of more than USD 1.1 trillion were issued worldwide.¹

In 2021, sustainability bonds accounted for more than 15% of the volume of newly issued Euro-denominated bonds. As a result, their weight in the Euro Aggregate universe increased to 7%. Just a few years ago, in 2018, sustainability bonds accounted for around 1%. What is more: in the meantime, 25% of all Euro zone issuers have brought a sustainability bond to market. The trend: upward. With a momentum similar to that seen over the past two years, we can expect sustainability bonds as a percentage of the overall market to further increase to over 10% in just a few years.

This means that the sustainability bond market segment has now outgrown its niche market, and developed into a broad, diversified bond segment. For evidence, just look at the issuers. Whereas in past years such securities were issued primarily by quasi-governmental and supranational issuers, the growth spurt seen in recent years is attributable to companies and financial institutions. To give you the figures: as of July 2022, the Euro-denominated universe consisted of nearly 1,000 issues by more than 350 issuers. The rating also shows that sustainability has long since matured. Indeed, the ratings distribution is comparable to that of the Euro Aggregate universe, and has the same average rating of Aa3/AA–.

However, the sustainable market segment has a longer duration (around one year) than the Euro Aggregate universe. One consequence of the segment’s rapid growth is that the longer maturity of new issues has increased the duration of the segment due to its high volume compared to the overall market. This feature, a longer time to maturity in a zero-interest environment, often deterred investors from incorporating more sustainability bonds when building their portfolio. The current turnaround in interest rates could mean that this feature is no longer a deterrent, and is possibly even becoming an extra advantage for sustainability bonds.

Bonds’ sustainable punch

Add to this the bare figures seen in a comparison of use-of-proceeds and traditional bonds. The sole difference between the two is in the use of funds – the issuer and risk are identical. In the past, there were some differences in price; these were especially obvious with green German Bunds that were issued as so-called “twin bonds”. That means that every green government bond has a counterpart with the same maturity, same coupon and same issue price. Empirically, the green versions of the three twin bonds issued so far always had a somewhat lower yield in the past. This finding also applied to other issuers. However, these lower yields (referred to as green premiums, or “greeniums”) have been decreasing recently. We expect these price differences to disappear altogether in the future as the size of the sustainability bond segment increases. Aside from the above, the following applies: the performance of sustainability bonds is comparable to that of traditional bonds; i.e., sustainability does not come at a cost to performance.

Quite the contrary: numerous studies in recent years have shown that sustainability bonds can improve the risk-adjusted return. Companies with a better ESG track record often perform better than ESG stragglers. As a result, investment strategies that promote a low-carbon future by investing in companies that offer solutions may provide attractive potential returns. For investors, that means that integrating sustainable investments into the investment strategy can increase the resilience of a portfolio, and compared to traditional investment strategies will generally provide downside protection over the long term.

What’s next? Whatever it is, it must be sustainable. The corresponding bonds will gain in importance, and higher interest rates will ensure positive nominal yields. Aside from the pure numbers, sustainability bonds help investors to accomplish their sustainability goals. In addition to earnings and risk, impact is likely to become another determining factor for the portfolio in the future. More and more attention will be focused on determining what positive contributions an investment can generate for the environment and society. On the one hand, therefore, there is demand for product providers to develop new investment concepts. However, there will also be a greater focus on the features of investment instruments. At the same time, sustainability bonds have a decisive advantage: today, they can already show in a clear, measurable way how they are making a positive contribution toward achieving environmental and social goals. Signs of the times? These also include sustainability bonds.

¹ Climate Bond Initiative, “Sustainable Debt Market …”, August 2022