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Capital Ideas

Investment insights from Capital Group

Categories
ESG
Are ESG bonds worth the “greenium”?
Tara Torrens
Fixed Income Portfolio Manager
Omer Brav
Quantitative Analyst

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


Our research indicates there is a spread concession for investors in ESG bonds. Given this valuation differential and a lack of standardization within the ESG bond markets, we think that investors are better served with a broader approach to ESG that explicitly incorporates E, S and G analysis into the investment process.



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 rating and credit risk as that entity’s traditional debt.


Green bonds have grown in popularity

Chart shows value of green bond issuance from 2014 through June 30, 2021. In 2014, the value of the bonds solds was $5 billion; in 2015, it was $8 billion. In 2016, it was $17 billion. In 2017, $31 billion; in 2018, it was $56 billion; in 2019, it was $89 billion; in 2020, it was $93 billion; in 2021, it was $32 billion as of June 30.

Source: Bloomberg. Data reflects fixed income instruments that will be applied toward green projects or activities that promote climate change mitigation or adaptation, or other environmental sustainability purposes. 2021 data is year to date as of June 30, 2021.

Thorough research is key


Given ESG bond designations are not standardized, 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 subaccount 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 step 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 (i.e., 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 model (see methodology in disclosures at end of article) to assess these differences in valuations and estimated that ESG bonds carried 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 may be 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 holds nearly US$650 million worth of green bonds, as classified by Bloomberg, across 65 issuers. But the pricing of ESG bonds is not straightforward. We have seen that 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.


Our ESG approach features three interrelated components

This graphic is an illustration of ESG approach at Capital Group. The three interrelated components are: 1. Investment frameworks, in which sector specialists identify the most important ESG issues to consider. 2. The monitoring process identifies issues that prompt analysts to dig deeper and provide insight. 3. Engagement and proxy voting enables us to influence ESG practices.

Source: Capital Group.

By not focusing exclusively on ESG bond designations, we seek to 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., we believe investors are not appropriately compensated for the risks) and issuers are expected to see improvement over time.


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



Tara L. Torrens is a fixed income portfolio manager with 17 years of industry experience (as of 12/31/20). She holds both a master’s degree and bachelor’s degree in finance from the University of Wisconsin-Madison and the Chartered Financial Analyst® designation.

Omer Brav is a quantitative analyst with fixed income research responsibility. He holds both a PhD and a master’s degree in finance from the Wharton School at the University of Pennsylvania. He also holds an MBA from Tel Aviv University and a bachelor’s degree in mechanical engineering from the Israel Institute of Technology.


Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
 

Methodology: 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.

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