CAPITAL

ESG-labelled bonds: looking beyond the ‘label’

ESG analysis will remain an important part of investment processes and shows tremendous current growth, but ESG-labelled bonds could play a less prominent role in sustainable investment strategies in the future, say Robb Barnum and Sean Conaghan of NEAM.

Green, social, and sustainable bonds—collectively known as environmental, social and corporate governance (ESG)-labelled bonds—specify that an amount equal to the bond proceeds will be invested in environmentally responsible initiatives or socially conscious projects, or, for sustainable bonds, a combination of both.

For the investor inclined towards sustainability, the growth in ESG-labelled debt outstanding, as discussed in a previous NEAM Quick Takes from December 2021, may seem like a great opportunity. However, investors must look beyond the ESG label since that label is not a guarantee that a bond will meet one’s ESG expectations.

For example, in the spring of 2021 an issuer of non-agency residential mortgage-backed securities labelled at least one of its securitisations as a “social” bond because the underlying loans were made to individuals whose borrowing needs did not conform to US agency standards and who therefore were, in the view of the issuer, underserved borrowers.

The loans did not conform to US agency standards due to factors such as income documentation, as the borrowers were largely self-employed entrepreneurs, and loan size, since some loans exceeded agency limits.

The average borrower in the pool of loans underlying this deal had an annual income of approximately $225,000, had the ability to make a down payment of approximately $150,000, and purchased a home worth approximately $650,000.

For comparison, the Government National Mortgage Association (GNMA), a US agency that supports first-time home buyers, low-income borrowers, and other underserved groups, also issued a bond in the spring of 2021 in which the average borrower had an annual income of approximately $60,000, made a down payment of approximately $10,000, and purchased a home worth approximately $195,000. The GNMA bonds did not have a social label.

Despite not having a label, investment in the GNMA deal may have been more consistent with the goals of an investor seeking to advance social causes than investment in the labelled non-agency residential mortgage-backed security (RMBS) securitisation (Figure 1).

Figure 1: Average borrower comparison

Source: Bloomberg

“Despite not having a label, investment in the GNMA deal may have been more consistent with the goals of an investor seeking to advance social causes.”

Robb Barnum, NEAM

Decisions, decisions

While we’ve wondered in some cases whether ESG-labelled bond proceeds are supporting the most worthy environmental or social initiatives, we believe that issuers have generally identified legitimate investments in sizes that correspond to the bond proceeds. Some utilities, for example, have invested in wind or solar power projects.

We question, however, whether the issuance of green bonds has any bearing on a utility’s decision to pursue such a project. Green bonds are generally issued with a yield similar to the level at which the company could issue an equivalent bond without the ESG label. With financing costs that approximate those of other bonds, the green bonds do not provide a cost advantage that would induce a company to undertake an otherwise uneconomic project.

In fact, many ESG-labelled bonds include a “look back” window that allows projects completed in the preceding years to qualify as investments funded by the ESG-labelled bond. Continuing with the utility example, we believe that renewable energy investments are driven by cost relative to alternatives as well as legislative and regulatory prompts to produce cleaner energy. A company might issue an ESG-labelled bond to modestly broaden the pool of investors to include some with specific ESG mandates and to demonstrate a focus on ESG considerations, but we would be surprised if ESG-labelled bond issuance factored meaningfully into any capital allocation decisions.

Moreover, the issuance of an ESG-labelled bond and the allocation of an amount equal to the proceeds toward environmentally or socially responsible investments has no impact on the potential ESG risks associated with the remainder of an issuer’s business.

From an investor perspective, ESG-labelled bonds are typically pari passu with other bonds issued by a given company. In other words, a senior unsecured green bond is in the same position in the capital structure as any other senior unsecured bond issued by a given company.

While an issuer pledges to allocate an amount equal to the bond proceeds to certain environmental or social projects, the ESG-labelled bonds are not secured by those projects or otherwise distinguishable from the other indebtedness of the company. Investors might choose to invest in ESG-labelled bonds to illustrate their awareness of ESG considerations and highlight investments in companies that are pursuing environmentally or socially responsible projects, but investment in ESG-labelled bonds does not help to manage ESG risks in a portfolio relative to investment in other bonds of the same issuers.

Our holdings of ESG-labelled bonds have increased as issuance has grown. We expect that insurers will highlight ESG-labelled bonds to stakeholders to illustrate their awareness of ESG considerations and their ownership of bonds issued by companies that are pursuing environmentally or socially responsible initiatives.

We wonder, however, if the current focus on ESG-labelled bonds will fade as ESG analysis evolves. When investors are seeking to manage ESG risks in their portfolios and invest in responsible and sustainable companies, we believe this analysis is best done at the issuer level, as opposed to focusing on the use of proceeds from individual bonds that may represent a very modest portion of an issuer’s capital structure.

At NEAM, we will continue to incorporate ESG considerations, among other factors, into our evaluations of issuer credit quality.

“Investment in ESG-labelled bonds does not help to manage ESG risks in a portfolio relative to investment in other bonds of the same issuers.”

Sean Conaghan, NEAM

Key takeaways

  • Issuers of ESG-labelled bonds can highlight environmentally or socially conscious projects while broadening the investor base to include those with specific ESG mandates.
  • Investors can illustrate their awareness of ESG considerations via participation in ESG-labelled bonds.
  • We have added ESG-labelled bonds when we otherwise believed that credit quality and valuations were attractive; we expect our holdings of ESG-labelled bonds to continue to expand as the market grows.
  • At present, ESG-labelled bonds generally trade at similar levels to equivalent bonds without proceeds earmarked for environmental or social projects.
  • We can envision a scenario in which ESG-labelled bonds trade at a premium, leading to outperformance for these securities; however, this is not, in our view, the most likely scenario.
  • We wonder if, in the long term, the current popularity of ESG-labelled bonds might fade, with investors focusing on a more holistic view of an issuer, instead of the use of proceeds for a specific bond, as they integrate ESG analysis into investment processes.

This article was originally published by NEAM in January 2022. This is not an offer to conduct business in any jurisdiction in which New England Asset Management, Inc. and its subsidiaries are not registered or authorised to conduct business.

Robb Barnum is the ESG risk manager at NEAM. He can be contacted at: robb.barnum@neamgroup.com

Sean Conaghan is an asset class specialist at NEAM. He can be contacted at: sean.conaghan@neamgroup.com

Image courtesy of shutterstock / DavidTB

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