Green, social or sustainable bonds (ESG bonds for the purpose of this article) are an increasingly popular way for fixed income investors to signal that they are taking ESG seriously. But how do they compare to traditional bonds? Is there a “greenium” to investing 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 standardisation 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?

Although there is a lack of standardisation around what constitutes an ESG bond, it’s widely accepted that ESG bond issuers use these 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.

As noted, use of the ESG bond designation is not standardised, producing a wide variety of interpretations by issuers. A recent green bond issue by a high yield industrial company offers an example of the need for careful analysis on the robustness of the designation beyond the label. This particular bond:
 

• Did not require escrow of proceeds for green uses, making it explicit that any proceeds would be held in a commingled corporate account.
• Did not identify specific green projects that the proceeds would fund, instead it listed 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 the proceeds weren’t used for green projects or ESG targets weren’t met.
• Did not create an event of default if the proceeds were not used for green projects, therefore creating no recourse for bond holders once bonds were issued.
• At issue, we estimated the approximate spread concession for investing in this “green” bond, relative to a traditional bond from that issuer, was about 25 basis points (bps).

 

Green bond supply history¹

Isolating the influence of ESG factors

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 valuation differential 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 – namely the ESG designation (albeit no standard set of criteria apply to any ESG designation) – while effectively holding constant all other factors that influence bond pricing. This allows us to determine if there is an average spread discount (lower compensation) on ESG bonds versus traditional bonds, for companies that issue in both markets, and if so, to quantify that spread concession.

 

1. Source: Bloomberg. As at June 2021.

 

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