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Are green bonds the route to sustainable fixed income?

It is fair to say that fixed income funds have lagged their equity peers in terms of adoption of environmental, social and governance criteria. Partly, this is structural – bond holders have less leverage than equity holders in bringing about change. But, with vast issuance of green bonds this year, investors may finally have a solution.

Recent analysis by market research consultancy Fundquisitive showed European fixed income funds have been laggards on ESG, with both demand and supply trailing other asset classes. Investors have been worried about whether the adoption of ESG criteria may dent performance, the difficulty of performance measurement and the risk of greenwashing.

Do green bonds answer the problem?

Until recently, the market was too small to present a realistic option for investors, but there has been vast issuance over the past five years. According to data from the Climate Bond Initiative, issuance has grown by an average of 60% since 2015. It says: “At the end of 2015, the green debt capital market had just reached a cumulative volume of $104bn. Five years later, the market surpassed the cumulative $1tn milestone in early December.”

The rate of growth looks likely to speed up as countries embrace green bond issuance. The UK government announced a green bond offering to support its zero emissions target in the recent budget. France and Germany have also launched green bonds, while Italy made its green bond debut with a €8.5bn sovereign bond at the start of March. Research from Swedish bank SEB expects around $500bn in green debt issuance in 2021.

Fatima Luis, senior fixed income portfolio manager at Mirabaud Asset Management, says: “The EU’s €750b Next Generation Fund will no doubt transform the sector. Globally, the green bond market is growing considerably. It is in demand and attracting new issuers across geographies, even in emerging markets. The number of issuers in developing markets is increasing (China and India for example).”

Equally, the market is diversifying.

In March this year, Public Power Corporation, Greece’s main power utility, raised €650m in Europe’s first sustainability-linked high yield bond sale. There are also social bond launches – such as the African Development Bank’s $3bn “Fight covid-19” bond launched last year. ‘Transition’ bonds – that aim to support the transition from fossil fuels to sustainable energy sources are also becoming commonplace.

Luis says that increasing demand is bringing better liquidity to primary and secondary markets: “Demand is on the increase particularly in the European government bond space where the green agenda is being more heavily pushed and is more advanced than in emerging markets or even the US. This also is providing more liquidity to the market. All stakeholders are demanding to see more results and alignments from their sustainable investments which inevitably leads to more liquidity especially in issuers that are repositioning their businesses for the longer term.”

Also, there is arguably more standardisation in the green bond market than elsewhere. David Katimbo-Mugwanya, manager on the EdenTree Responsible and Sustainable Sterling and Short Dated Bond funds, says: “It is important to note that issuers cannot just label their bonds green. Use of the green bond categorisation is subject to the voluntary Green Bond Principles (GBP), created by the International Capital Markets Association (ICMA), whose transparency and disclosure guidelines seek to uphold the market segment’s integrity.”

There are also a growing number of green bond funds on the market. Amundi, Bantleon, Mondrian Generali, Robeco and BNY Mellon, among others, have launched green bond funds over the past 12 months. Ultimately, the picture is one of a market that increasingly offers a viable option for investors.

Boils down to cost

However, inevitably, there are some challenges. For example, Fidelity International is concerned on pricing: “While we support the environmental aims of green bonds, we take issue with their pricing. For example, we note that they often trade at a premium to their ‘brown’ counterparts…This so-called ‘greenium’ appears to persist even where the credit risk of green bonds matches that of brown bonds issued by the same company.”

The concept of a ‘greenium’ is disputed, but recent green bond issuance by the German government appeared to prove its existence. Premium pricing is not necessarily a problem as long as demand holds up (and also happens in the equity market) but may be an issue if sentiment swings for any reasons.

Equally, Luis admits there can still be problems of transparency and standards in emerging markets: “There’s still a lack of clear ESG management practices in emerging markets and so the absence of a global standard on green bond reviews and standards means that as investors, we might receive partial or incomparable information from issuers on green bonds and use of proceeds.”

Investors will also need to be wary of the significant issuance likely to come to market this year and ensure that high demand does not see credit standards slip. Nevertheless, the green bond market is looking increasingly mature and should fill a hole in investors’ sustainability portfolios.

Part of the Bonhill Group.