All Things Considered: A Framework For Assessing ESG-Labeled Bonds

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By Salima Lamdouar; Patrick O’Connell, CFA; & Tiffanie Wong, CFA

ESG in Action

Today’s bond market presents distinctive alternatives for accountable investing within the type of ESG-labeled bonds. These relative newcomers to the market can provide their issuers an ESG halo and even decrease their price of debt. Investors like them as a result of they’ll ship a measurable influence. But as the marketplace for these bonds grows, so too do the challenges. In this paper, we describe our course of for assessing ESG-labeled bonds and present that, by systematically making use of this framework, traders may help set a gold normal for the market, keep away from surprises from controversy and greenwashing, and probably generate extra alpha over time.

Nearly US$800 billion ESG-labeled bond issuance in 2021

1%–5% Range of “greenium,” March 31, 2022

0.20 Median possession focus rating for inexperienced bonds, in contrast with 0.06 for conventionals

Increasingly, at this time’s fixed-income market presents distinctive alternatives for accountable investing within the type of environmental, social, and governance (ESG) labeled bonds. These relative newcomers to the market can provide their company, sovereign or securitized issuers a welcome ESG halo and will even decrease their price of debt by attracting new traders. In flip, traders are drawn to ESG-labeled bonds as a result of they’ll ship a measurable—and significant—social or environmental influence.

Unfortunately, as demand surges for accountable investing decisions and the marketplace for ESG-labeled bonds balloons, so too do the challenges. It’s difficult for traders to pick bonds with the proper buildings and options that may meet their ESG guarantees as marketed. That’s why traders and their bond managers will need to have a disciplined framework for assessing ESG-labeled bonds.

Bigger, Broader, Better: The Rise of ESG-Labeled Bonds

Heightened demand for accountable investing has led to an explosion in issuance of ESG-labeled bonds equivalent to inexperienced bonds, social bonds and sustainability-linked bonds. Nearly US$800 billion in ESG-labeled bonds had been issued in 2021, accounting for about one in 4 investment-grade and high-yield new points in Europe alone (Display). A greater variety of corporations is embracing ESG-labeled bonds too, many inside industries which are more and more confronted with challenges—and alternatives—to decrease the carbon depth of manufacturing processes and shopper items, equivalent to chemical compounds, auto, telecom and shopper merchandise.

Corporate ESG Issuance Continues Rapid Growth

Europe Still Leads, however Other Regions Are Surging

Side by side displays show massive surge in issuance diversified by region and type of ESG-labeled bond.

Analysis supplied for illustrative functions solely and is topic to revision. APAC = Asia-Pacific As of December 31, 2021 (Bloomberg)

ESG-labeled bonds come in several types. If they’re true to their label, project-based bonds equivalent to inexperienced bonds, sustainability bonds and social bonds use the proceeds for a particular environmental or social initiative. In distinction, sustainability-linked bonds aren’t related to a mission however as a substitute goal firmwide key efficiency indicators (KPIs); if they arrive up quick, the coupon charge sometimes resets increased, offering incentive for the issuer to fulfill its targets or incur the next price of debt.

ESG-labeled bonds profit their issuers in a number of methods. In addition to the goodwill they create—the ESG halo impact—ESG-labeled bonds may be cheaper to situation than comparable standard bonds. High demand might reward corporations with extra modest coupons, which may decrease the price of the debt over the long term.

As a outcome, ESG-labeled bonds have a tendency to supply traders barely decrease yields in comparison with standard bonds. We suppose the trade-off is worth it once we contemplate what well-structured bonds can obtain.

Most clearly, they’ll make a significant distinction to one thing traders consider in, like addressing social inequities of their communities or supporting the transition to internet zero. They additionally give traders, bankers and different stakeholders a say in how corporations function, even serving to to steer company conduct in a greater course. Based on transcripts from earnings calls and different displays, extra traders than ever are brazenly difficult management to undertake stronger and extra clear ESG philosophies and actions all through their operations.

Additionally, ESG-labeled bonds might expertise smaller drawdowns in unstable markets, serving to to buffer portfolio efficiency. Historically, the premium for ESG-labeled bonds versus standard bonds—often called a “greenium”—expanded when volatility spiked and spreads widened, as they did on the onset of the COVID-19 pandemic, which cushioned ESG-labeled bond unfold widening (Display).1

Greenium Narrows when Spreads Widen

European Corporate Bonds: Spreads (Basis Points)

Line chart shows credit spreads widening sharply in 2020; line for greenium simultaneously declines sharply.

Analysis supplied for illustrative functions solely and is topic to revision. Through February 28, 2022 Green bonds are represented by the ICE EUR Green Bond Index; Investment-grade bonds are represented by the ICE BofA 5–10 Year Euro Corporate Index; A-rated bonds are represented by the ICE BofA 5–10 Year Single-A Euro Corporate Index. (Bloomberg and ICE Data Services)

This explains why ESG-labeled bonds outperformed their standard friends when the coronavirus pandemic struck (Display).

Green Bonds Outperformed when Pandemic Struck

European Corporate Bonds: Total Return

Line chart shows return for green bonds significantly higher than other European credits between January and June 2020.

Analysis supplied for illustrative functions solely and is topic to revision. January 1, 2020, by means of June 30, 2020 Green bonds are represented by the ICE EUR Green Bond Index; Investment-grade bonds are represented by the ICE BofA 5–10 Year Euro Corporate Index; A-rated bonds are represented by the ICE BofA 5–10 Year Single-A Euro Corporate Index. (Bloomberg and ICE Data Services)

We suppose this drawdown mitigation could also be the results of investor dedication to this nascent market and better focus of possession within the fingers of forward-looking, long-term traders. Green bonds have the next concentrated possession rating than standard bonds (Display).

Green Bond Ownership Is More Highly Concentrated

Herfindahl-Hirschman Index of Ownership Concentration

Average score for green bonds is .28. For conventionals it’s .15. Median for green bonds is .20. Conventionals .06.

Analysis supplied for illustrative functions solely and is topic to revision. As of December 21, 2021 (Fatica, Serena and Panzica, Roberto, Sustainable Investing in Times of Crisis: Evidence from Bond Holdings and the COVID-19 Pandemic)

For all these causes, we consider ESG-labeled bonds will proceed to have a big and rising position in making the world a greater place.

Challenges Proliferate with Rapid Growth

A brand new market that grows to greater than US$2 trillion in cumulative issuance in a short while comes with inherent challenges. One such problem is the shortage of minimal necessities for issuing an ESG-labeled bond. For instance, there are not any hard-and-fast guidelines behind certifying a inexperienced bond or whether or not a sustainability-linked bond’s targets are significant, related or bold.

Several organizations, such because the International Capital Market Association and the Climate Bonds Initiative, have proposed voluntary tips. But it’s typically arduous to discern if proceeds are earmarked for ESG objectives or simply enterprise as standard. And some ESG-labeled bonds is likely to be used as a fig leaf—a well-placed distraction from tougher or concrete actions wanted elsewhere within the enterprise.

With many incentives however few necessities, greenwashing—the misrepresentation of an funding’s sustainability traits or advantages—is a widespread drawback. The proliferation of greenwashing and different challenges has spawned many critics of ESG investing. But we expect these challenges can provide necessary takeaways for traders to assist them discern between ESG-labeled bonds that may or received’t do as marketed and to assist add alpha to portfolios.

Key takeaway #1: Companies that situation ESG-labeled bonds open themselves to increased ranges of ESG scrutiny. The firm needs to be prepared and keen to reply powerful questions from all instructions—traders, managers, bankers, the media—to again up the bond’s ESG label and clarify the way it enhances the corporate’s values and tradition.

Key takeaway #2: When an organization points an ESG-labeled bond, traders should scrutinize the issuer’s ESG observe file. A inexperienced bond issued by an organization identified for environmental mishaps could be disingenuous and an instance of blatant greenwashing.

Key takeaway #3: Investors ought to determine and keep away from poorly structured ESG-labeled bonds to assist compel issuers to lift the bar. As bond shortcomings are extra brazenly documented, issuers must increase their recreation to encourage better participation.

A Framework for Selecting ESG-Labeled Bonds

Our personal ESG-labeled bond evaluation begins with a call tree (Display) that, by means of a sequence of hard-hitting questions, permits us to handle the above takeaways and separate the wheat from the chaff.

AB’s Framework for Assessing ESG-Labeled Bonds

Two-level decision tree. Bonds that don’t pass Level 1: Avoid. Bonds are sorted by Low, Moderate and High Score in Level 2.

Analysis supplied for illustrative functions solely and is topic to revision. (AllianceBernstein (AB))

This resolution tree poses questions at two ranges:

Level 1: Is the borrower freed from ESG controversy? Our prime precedence is to find whether or not the issuer is saddled with ESG controversy. For instance, an organization with a historical past of polluting would wrestle to persuade the general public that its ESG bonds had been greater than lip service. In truth, merely issuing an ESG-labeled bond holds a agency as much as additional media scrutiny, the place even a touch of hypocrisy can injury reputations in a single day and damage bond efficiency. Therefore, this threshold is deliberately onerous.

At this stage, we additionally contemplate an organization’s elementary ESG scores in AB’s proprietary credit standing and risk-scoring platform, PRISM. In our view, if the issuer’s ESG rating is low, whether or not on particular person or mixed environmental, social or governance standards, it mustn’t situation an ESG-labeled bond. For instance, an organization might have a repute for furthering environmental causes, however different controversial actions will knock it out of the operating for issuing ESG-labeled debt.

In addition to scrutinizing particular person corporations for potential headline-making controversy, our analysis factors to some sectors being a mismatch for ESG-labeled bonds—particularly, people who generate significant revenues immediately from tobacco, grownup leisure, alcohol, gaming, weapons and agriculture immediately tied to deforestation, equivalent to palm oil. Fossil gasoline corporations received’t be credible ESG-labeled bond issuers except additionally they have a reputable decarbonization plan.

Companies that may’t go the Level 1 threshold mustn’t situation ESG-labeled bonds, and in the event that they do, traders ought to keep away from them. On the opposite hand, issuers that go our Level 1 threshold are suited to issuing ESG-labeled bonds, and so their ESG-labeled bonds proceed to the following stage in our resolution tree.

Level 2: Are the KPI targets for sustainability-linked bonds or using proceeds for project-based bonds acceptable, and are the bond’s mechanics applicable? An ESG-labeled bond’s targets and use of proceeds have to be applicable for each the corporate and its business. For inexperienced or social bonds, meaning the proceeds should clearly align with inexperienced or social objectives; for sustainability-linked bonds, the KPI goal have to be among the many most related ESG metrics for the issuer’s business and be sufficiently bold that its influence might be significant and lasting.

But that’s not all. At this stage, we additionally contemplate whether or not using proceeds might trigger materials hurt in different respects. For occasion, a proposed hydroelectric dam financed by means of a inexperienced bond might create extreme injury to the native setting and communities.

Next, are the bond’s mechanics applicable? Answers right here reveal the extra tactical points of the ESG-labeled bond situation. Will the funds raised be deployed in a well timed method? Is the timeline for assembly the KPI cheap? If a sustainability-linked bond misses its goal, will the step-up penalty be consequential sufficient? And lastly, does the corporate plan to situation extra ESG-labeled bonds down the street, contributing to a extra sturdy ESG market?

Investors might wish to decrease publicity to ESG-labeled bonds that don’t go this stage. However, if the bond checks some however not all “yes” packing containers, traders ought to consider it like a standard bond. Finally, if it resoundingly passes the brink, we contemplate it a reasonably structured ESG-labeled bond and consider it accordingly. That normally means being keen to simply accept a modestly decrease yield, often called a greenium, in trade for sometimes smaller drawdowns in periods of market stress, as mentioned above.

This framework helps us quickly vet noncontroversial, well-structured ESG-labeled bonds. But it additionally fosters open and clear communication amongst stakeholders, from traders to bankers to issuers. It helps issuers higher perceive why traders resolve for or in opposition to shopping for their bonds and creates alternative for them to revise the phrases of recent points when it’s prudent. Moreover, by adhering to such a framework, traders may help increase the bar for ESG-labeled bond issuance and have an effect on company conduct over time.

Less Greenwashing Can Mean More Alpha

Across international fixed-income markets, ESG-labeled bonds are priced considerably increased—and thus provide modestly decrease yields—than their standard cohorts. According to our above framework, accepting this minor greenium can, counterintuitively, enhance alpha. Currently, this greenium ranges between 1% and 5% of the typical unfold for the area and business of situation (Display). Europe sees the smallest greeniums, because it has the most important provide of ESG-labeled bonds.

ESG-Labeled Bonds Trade at a “Greenium”

Table shows greenium by region (Europe, US and EM) and type (corporates, sovereigns, financials). They range from 1 to 5%.

Analysis supplied for illustrative functions solely and is topic to revision. As of March 31, 2022. *Greenium as a % of the sector’s option-adjusted unfold (Bloomberg and AllianceBernstein (AB))

In our evaluation, paying a greenium to put money into robust ESG-labeled bonds is a worthwhile trade-off. As famous beforehand, well-structured ESG-labeled bonds are typically much less unstable and thus are more likely to entice extra flows and carry out higher in periods of market stress. That ought to result in higher efficiency over time as spreads tighten extra in comparison with standard bonds. Weaker ESG-labeled bonds—these susceptible to controversy and greenwashing—are unlikely to see this unfold enchancment.

Regardless, at this time’s market lumps all ESG-labeled bonds collectively in order that proper now greeniums not often differentiate between robust and poorly structured points. Once the market does start to distinguish, savvy traders will doubtless profit. That’s but one more reason to use a disciplined framework to the evaluation of ESG-labeled bonds.

Establishing a Gold Standard for ESG-Labeled Bonds

Without globally accepted requirements for what constitutes an ESG-labeled bond, the onus is on traders to filter the great from the unhealthy. It’s critically necessary, due to this fact, that traders have candid conversations with issuers, bankers and different stakeholders to lift the arduous questions that may guarantee a bond is well-structured and more likely to accomplish its said objectives.

By constantly and systematically making use of a framework for assessing ESG-labeled bonds, traders may help set a gold normal for issuance throughout this rising market, keep away from surprises from controversy and greenwashing, and probably generate larger alpha over time.

1 Fatica, Serena and Panzica, Roberto, Sustainable Investing in Times of Crisis: Evidence from Bond Holdings and the COVID-19 Pandemic (December 21, 2021). Available at SSRN.

The views expressed herein don’t represent analysis, funding recommendation or commerce suggestions and don’t essentially signify the views of all AB portfolio-management groups. Views are topic to vary over time.

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Editor’s Note: The abstract bullets for this text had been chosen by Seeking Alpha editors.

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