Green bonds so far remain a relatively modest niche in the business of raising funds for sustainable projects such as carbon-reducing technology, for example. The author of this article urges investors and their advisors to show caution about a field that is taking time to grow.
Around the world, one investment trend has been that of “green bonds” – loans to businesses and organisations investing in projects such as renewable energy, technology that doesn’t produce much carbon dioxide, and related fields. In a world where yields in many asset classes have been squashed by ultra-low/negative interest rates, the chase for yield opens up new opportunities – and risks. And the drive towards “green” investing also reflects concerns, whether fully justified or not, about the state of the environment. At times, however, there have been concerns about “greenwashing” – dressing up conventional investing in the garb of environmentalism. Another concern is whether such investing can match or beat conventional ways of putting money to work.
To examine the terrain is Simon Lue-Fong, head of fixed income at Vontobel Asset Management, part of Switzerland’s Vontobel. The editors of this news service are pleased to share these views and invite responses. Please enter the debate! The usual editorial disclaimers apply. Email firstname.lastname@example.org and email@example.com
There is a looming stampede into green bonds, if you believe all the hype. Following Germany and Sweden, the UK also hopes to capitalise as Chancellor Rishi Sunak plans to reveal a timeline for the UK’s first green gilt issuance at the Budget in March. It all sounds great in theory but the fact is that green bonds are still a relatively small niche to secure funding for sustainable projects. More power rests in the vast realm of general fixed income markets, which tend to be underestimated as a powerful place for pushing sovereign and corporate issuers to implement change. Of course engagement is an area that is still maturing in fixed income, but there are potent pricing mechanisms at play in primary and secondary fixed income markets that bond investors can use to have a tangible impact.
The common perception is that impact goes hand in hand with power, which is why influencing company management tends to be considered a privilege of equity investors. Equity investors own the companies and have voting rights, while fixed income investors are merely capital lenders with credit terms with less leverage on management decisions. This is accurate but it ignores the fact that bond investors are capital providers, whose convictions are reflected in market prices and bond valuations that determine a company's cost of capital. As ESG (environmental, social and governance) matures in bond investing and investors increasingly practise ESG integration in their bond selection processes, bad ESG headlines will force a company to pay more on their bonds, as responsible investors start to shun culprits by pushing down the bond price and driving up the yield.
Now, critics might say that the real action takes place in primary markets, where capital is allocated, and not in secondary markets, where it only trades hands. However, this is only partly true in fixed income markets. With very few exceptions, companies and governments are serial issuers that tap the market repeatedly in order to refinance themselves. This means that they roll over their debt and any primary issuance is priced off the secondary market. So, if a company has a questionable ESG track record, investors are likely to be wary of the risks associated with them. Consequently, they are likely to demand a higher yield on the issuer's bonds in the secondary market, which has a direct effect on the pricing mechanism of new issuances in the primary market. Higher yields translate to higher interest expense, which hits the company where it hurts: the bottom line.
The value of engagement has also gained attention, largely through belligerent equity investors forcing companies into action with the goal of weeding out obvious weaknesses for the benefit of shareholders. In fixed income, engagement is a less glorious affair. Without the option of proxy voting, bond investors' power to engage with issuers has tended to be more implicit than explicit and this really needs to develop further in order to really bring about change. As capital providers, bond investors have direct access to company management and government officials and are able to raise contentious issues and address potential shortfalls – the bigger the bond share the investor holds, the better of course.
However, to avoid being palmed off with a polished PR answer, more collective action is required from bond investors who tend to only come together in the case of defaults and debt restructurings. The good news is that, in light of ESG's fast advance, it might only be a matter of time until bond investors find a common forum to press issuers on their concerns - not least because, ultimately, ESG improvement can have a direct bearing on credit quality.
So, bond investors do have quite some sway. This comes with responsibility since leaving low, yet up-levelling, ESG performers behind by excluding them from an investable universe would cut them off from funding, barring any further progress. There are two aspects, which can prevent this from happening:
Market mechanisms will incentivise issuers to improve on ESG concerns. As described above, low ESG performers unwilling to change are likely to be penalised by the market through a higher yield.
Conversely, improving ESG laggards are likely to see their funding costs decrease over time as they progress on ESG, while investors benefit from capital gains as bond prices rise. This is a win-win situation, which will strongly incentivise companies to model their behaviour on their more successful peers. At the same time, investors are encouraged to scour the earth for issuers who are on a positive ESG trajectory to harvest the returns associated with the spread tightening potential that these issuers harbour.