Green, social or sustainable bonds (“ESG bonds”) have become an increasingly popular way for fixed income investors to signal that they are taking ESG seriously. As can be seen in the chart below, green bond supply hit a record high in the first half of 2021. In June, sales of new green bonds rose to US$79 billion¹, putting new issuance significantly ahead of this point last year.

But how do ESG bonds compare to traditional bonds? Is there a “greenium” (ie a higher price paid) to invest in this way and if so, how can investors avoid paying it?

 

What are ESG bonds?

While there is no standard definition around what constitutes an ESG bond, it’s widely accepted that ESG bond issuers use the instruments to raise proceeds to fund sustainable projects, whether these are environmental or social in nature.

Typically, a corporation’s ESG bond issuance is backed by its balance sheet, and therefore carries the same ratings and credit risk as that entity’s traditional debt.

Thorough research is key

Given ESG bond designations are not standardised, this can produce a wide variety of interpretations by issuers, highlighting the need for careful analysis on the robustness of the designation beyond the label.

As an example, a recent green bond issue by a high yield industrial company:

 

Did not require a sub-account of proceeds for green uses, thus making it explicit that proceeds would be held in a commingled corporate account.

Did not identify specific green projects that the proceeds would fund, instead listing generic ongoing projects that proceeds could be used to support.

Did not identify any explicit ESG/green goals or thresholds for the issuer to meet.

Did not offer a coupon step³ to investors if proceeds weren’t used for green projects or ESG targets weren’t met.

Did not create a default scenario if proceeds were not used for green projects, thus creating no recourse for bond holders, once bonds were issued.

At issue, we estimated the approximate premium (ie higher cost) for investing in this “green” bond, relative to a traditional bond from that issuer, was about 25 basis points.

Comparing ESG bonds and traditional bonds

To evaluate how “ESG” an investment is, it must be possible to isolate the influence of ESG factors while effectively holding constant all other influencing factors.

This is difficult to achieve in the stock market because no two companies are identical. Isolating stock price differences that are attributable exclusively to ESG factors and comparing relative valuations on this limited basis is very difficult.

It’s different in the bond market. Here we can more readily assess the differences in valuations between traditional and ESG bonds if we compare bonds within a single issuer’s capital structure. It’s easier to isolate the influence of ESG factors while effectively holding constant all other factors that influence bond pricing.

At Capital Group, we built a model⁴ to assess these differences in valuations and found that ESG bonds carry a price premium or ‘greenium’ resulting in a reduction of yield (or return) of 4.1 basis points and 3.1 basis points relative to their adjacent non-ESG bonds, in the samples we gathered for November 2020 and May 2021, respectively. In other words, investors are often paid less, to invest in ESG-designated bonds.

Integrating E, S and G

Of course, not all ESG bonds are the same and many provide attractive investing opportunities. At the time of writing, Capital Group owns nearly US$650 million worth of green bonds, as classified by Bloomberg, across 65 issuers. But the pricing of ESG bonds is not straightforward and as we have seen their designation is subject to interpretation by issuers, highlighting the need for careful analysis before investing. The ESG bond market is also still small relative to the greater fixed income investable universe. It is this broad universe that ensures an ample supply of opportunities across market environments.

That’s why we don’t focus solely on investing in ESG-designated bonds. Rather, by integrating ESG considerations into our investment process (illustrated by the graphic below), we can identify issuers that face risks – and opportunities – broadly and comprehensively across “E,” “S,” and “G” factors.

 

By not focussing exclusively on ESG bonds we avoid this valuation concession. Instead, we have the opportunity to use both our fundamental credit research, coupled with our in-depth ESG research, to identify long-term opportunities where ESG risk is currently mispriced (i.e. investors are excessively compensated for the risks) and issuers are expected to see improvement over time.

We believe this is likely to produce consistently superior long-term investment returns, relative to a designated ESG bond-only strategy.

 

1. Source: BAML

2. As at July 2021. Source: Bloomberg

3. A bond with interest coupons that change to predetermined levels on specific dates.

4. To assess the impact of the ESG designation, we began by estimating the fair value for all green, social, and sustainable bonds outstanding as of November 2020 and May 2021. We did this by determining the valuation of adjacent traditional bonds on the issuer’s yield curve. Only bonds with the same currency, seniority, collateral, and rating, with durations within one year of the ESG bond, were used to assess fair value. In many cases sufficiently comparable bonds did not exist, and therefore the number of designated bonds under study was reduced to 843 and 1,175 bonds for the November 2020 and May 2021 samples correspondingly. After removing the most extreme top and bottom two percentiles of the universe, the final November 2020 and May 2021 samples amounted to 809 and 1,128 bonds respectively.