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Energy
Weighing up the costs of ESG bonds
Tara Torrens
Fixed Income Portfolio Manager
Omer Brav
Quantitative Analyst

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.


 


Risk factors you should consider before investing:

  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
  • Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.


Tara L. Torrens is a fixed income portfolio manager at Capital Group. She has 17 years of investment experience, all with Capital Group. She holds both a master’s degree and bachelor’s degree in finance from the University of Wisconsin-Madison. She also holds the Chartered Financial Analyst® designation. Tara is based in New York.

Omer Brav is a quantitative analyst at Capital Group, with fixed income research responsibility. Omer 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 the Tel Aviv University and a bachelor’s degree in mechanical engineering from the Israel Institute of Technology. Omer is based in New York.


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Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.