Environmental, Social and Governance (ESG) bonds have become an increasingly popular option for forward-thinking fixed-income investors. Green bond supply hit a record high in the first half of the year ($79 billion in June 2021).
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?
What are ESG bonds?
Let’s start with what constitutes an ESG bond. “While there is no standard definition, it’s widely accepted that ESG bond issuers (such as governments and private companies) use the instruments to raise proceeds to fund sustainable projects that meet environmental, social or governance-related criteria” say Tara Torrens and Omer Brav.
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.
“Given ESG bond designations are not standardised, this can produce a wide variety of interpretations by issuers. That’s why investors need to look beyond the label and analyze each issue before investing.”
Investors need to look beyond the label and analyze each issue before investing
As an example of the type of issues that need to be considered, a recent green bond issue by a high-yield industrial company didn’t require a sub-account of proceeds for green uses, didn’t identify specific green projects that the proceeds would fund, didn’t identify any explicit ESG goals or thresholds for the issuer to meet, didn’t offer a coupon step to investors if proceeds weren’t used for green projects or ESG targets weren’t met, and didn’t create a default scenario if proceeds weren’t used for green projects. “In this example, we estimated the approximate premium (i.e. higher cost) for investing in this green bond was about 25 basis points.”
ESG bonds vs. traditional bonds
To evaluate how “ESG” an investment is, you have to be able to pinpoint the influence of ESG factors. This is difficult to achieve, especially in the stock market, because no two companies are identical. Isolating stock price differences directly related 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 offered by a single issuer. That makes it easier to understand the influence of ESG factors.
“Using a model to assess these differences in valuations, we found that ESG bonds carry a price premium (or ‘greenium’) resulting in lower yields compared to their adjacent non-ESG bonds. In other words, investors are often paid less to invest in ESG-designated bonds.”
ESG bonds carry a price premium resulting in lower yields compared to their adjacent non-ESG bonds. In other words, investors are often paid less to invest in ESG-designated bonds.
Which ESG strategy is right for you?
Fortunately, most ESG bonds do provide attractive investing opportunities. Capital Group, for instance, holds nearly $650 million worth of green bonds across 65 issuers.
Relative to the broader fixed-income investable universe, which offers an ample supply of opportunities across market environments, the ESG bond market is still small. “That’s why we don’t focus solely on investing in ESG-designated bonds. Rather, by integrating ESG considerations into our investment process, we can identify issuers that face risks – and opportunities.”
Interested in learning more? Further data and analysis by Tara Torrens, Fixed Income Portfolio Manager at Capital Group, is available here.
“By not focusing exclusively on ESG bonds, we avoid compromising on valuations. Instead, we use our fundamental credit research coupled with our in-depth ESG research to identify opportunities where ESG risk is currently mispriced and issuers are expected to see improvement over time.” A winning strategy that can produce consistently superior long-term investment returns.
Interested in finding out more? Contact us!