A beginner’s guide to ESG-labelled bonds

Achieving the 17 Sustainable Development Goals and getting to a net-zero carbon economy is as much, if not more of a financial, than a technology challenge.

To reach net-zero greenhouse gas emissions alone will require around USD4 trn[i] in annual clean energy investment globally. The USD100+ trn global bond market will therefore play a key role in achieving these global ambitions in the years to come. We share five key points about ESG[ii]-labelled bonds.

1. The ESG, fixed income market has essentially converged into five categories: green bonds, transition bonds, social bonds, sustainability bonds and sustainably-linked bonds.

Green bonds

Currently, green bonds dominate the market, representing around 55% of the ESG-labelled bond market. Proceeds from green bonds are committed to climate and environmental projects and these bonds usually carry the same credit rating as their issuers’ other debt obligations.

Transition bonds

Introduced in 2017, transition bonds are designed to help firms with high greenhouse gas (GHG) emissions to finance a transition to greener or lower-carbon activities or methods of production. The transition bond market is still at a nascent stage of development, with only a handful of issuers to date – cumulative issuance is just over USD7 billion across 16 bond deals since 2017. Given the broad range of industries that could benefit from transition finance, this market has potential for significantly more growth and development.

Social bonds

The proceeds from a social bond go towards projects with positive social outcomes, like affordable basic infrastructure (e.g. clean drinking water) or access to essential services (e.g. health, education, etc.), for example. While still in the early stages of development, the social bond market grew exponentially in 2020 as the Covid pandemic led to a resurgence in social investment projects.

Sustainability bonds

Proceeds from sustainability bonds are applied to the delivery of environmentally sustainable outcomes or some combination of green and social projects for an identified target population.

Sustainability-linked bonds

Sustainability-linked bonds are general-purpose instruments that – unlike “use-of-proceeds” debt such as green bonds – don’t compel issuers to direct all proceeds to pre-defined sustainability projects. Instead, the borrower commits to achieving a sustainability performance target. Key features of these increasingly popular securities (and their equivalents in loan markets) are the reward-penalty mechanisms that link discounts (coupon step-down), or premiums (coupon step-up) applied to coupon rates or principal payments to an issuer’s ESG rating or other key performance indicators.

2. The ESG debt market is still quite small, with ES G-aligned securities only representing around 3% of global bond markets today. But in many ways, the preconditions for rapid market growth are already in place:

Strong investor demand for sustainable investments has driven product innovation in recent years, alongside steady and gradual improvements in market depth and liquidity. 2021 saw a record surge in flows to ESG-aligned securities. Sustainable debt issuance also hit a fresh high of over USD 1.4 trn in 2021, almost double the pace of 2020, which was itself a record year.

The top down push towards sustainable investment from policy makers and regulators is one of the biggest drivers of market growth. And it’s been in the works for years, especially in the EU and the UK. It’s also championed by key international financial institutions and the multilateral development banks which are now increasingly working hand-in-hand with the private sector.

Looking ahead, the Institute of International Finance estimates that ESG debt issuance could reach over USD2.2 trn in 2022 and over USD4.5 trn by 2025, with green bonds continuing to dominate, but there will also be significant growth in other key areas like sustainability linked bonds and social bonds.

3. In emerging markets, while we do not see the same variety of ESG-debt instruments yet, we can expect a huge amount of issuance over the years to come.

We have already started to see near exponential growth over the last year in terms of the amount of issuance in EM credit markets. In 2021, ESG local currency bonds accounted for close to 20% of overall issuance, up from just 7–8% just a few years earlier. As reiterated at Cop 26, emerging markets must play a critical part of the climate solution. On the one hand, many EM economies are the most vulnerable. For example, studies show that in Southeast Asia, economic output in some countries could be 60% lower by 2100 if climate targets aren’t met. On the other hand, many EM countries are also among the largest emitters of greenhouse gases, so they must be part of the solution.

But emerging markets can often be innovators, with some arguably leading the way in ESG debt. Last year, Chile exclusively issued ESG-labelled bonds in hard currency and zero conventional bonds. In March of this year, Chile became the first sovereign in the world to issue a sustainability-linked bond.

4. From a returns perspective, since the end of 2017, volatility-adjusted returns on green bonds have been very similar to those of unconventional bonds.

Some investors believe that ESG bonds should better weather periods of market stress. Their main argument being that this type of paper tends to be held by institutional investors with long term mandates (i.e. “buy & hold” investment horizons). However, while there is no evidence that ESG bonds outperformed their non-green counterparts during the 2020 Covid-19 sell-off, ESG bonds appeared to trade in line with non-ESG bonds during the 2022 early sell-off too.

5. Liquidity in ESG-labelled bonds remains an issue as investors in these instruments tend to have more buy and hold strategies, which has a liquidity-dampening effect.

In addition, many investors of these instruments are in the process of decarbonising their portfolios in commitment to net zero, a driver that is unlikely to diminish anytime soon. However, trading volumes in ESG-labelled bonds are increasing.

Today, green bonds are the most liquid segments of the market, followed by social bonds, which in part reflects the outstanding amount of the available securities. Looking ahead, more data is needed on how ESG-labelled bond liquidity holds up in times of financial market stress. So far at the peak of the COVID crisis, we saw a significant pickup in trading activity in green bonds, which is a good sign. This primarily reflects the ongoing demand for ESG assets on the back of investors trying to meet their net-zero targets, particularly from institutional investors committed to portfolio decarbonisation initiatives. But this will be an area to watch closely in future times of market stress.

[i] Source : UN Framework Convention on Climate Change, 2021

[ii] Environmental, social and governance

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