Sustainability and the power of bonds

Last year, investor engagement triggered an important change in tack at a large US pharmaceuticals producer, leading to it making clear social commitments via access-to-medicines programmes. Investor engagement also brought pressure to bear on more than 50 US energy companies, urging them to set more aggressive targets for methane emissions abatement and to document their emissions abatement performance. The oil and gas industry is the second biggest source of methane emissions, which are the second largest cause of global warming according to the International Energy Agency (IEA).

At a time when investing along environmental, social and governance (ESG) lines in the world of equities has arguably moved from a quiet backwater to the mainstream, ESG-related engagement is often assumed to predominantly come from shareholder activism. But, in both cases, the pressure came from bondholders.

Unprecedented growth

In the past year alone, ESG-related bond issuance totalled more than $1tn, which is equivalent to almost one third of the outstanding ESG bond universe, making it the fastest-growing segment of the global fixed-income market.

One of the reasons for this prolific growth is that investors are increasingly aware of the need to incorporate ESG factors across their entire portfolios, including fixed-income. “There are a number of ways investors have approached this, ranging from integrating ESG risks into the investment process to optimising for ESG metrics and including ESG bonds in their portfolio,” says Tina Adatia, Executive Vice President, Global Head of ESG Product Strategy at PIMCO, one of the largest investment-management firms.

Importantly, Adatia also highlights that fixed-income investing has a unique ability to influence a company’s sustainability journey and long-term ESG goals. There are two predominant reasons for this: first, in terms of size, the global bond market is larger than the global equity market and, secondly, new issuance dwarfs the issuance of shares¹.

“Critically, as borrowers need to refinance their obligations, it provides fixed-income investors and asset managers a chance to engage with issuers on a recurring basis as these companies and governments come to the primary market to raise funds,” says Adatia. Often, issuers are also raising debt financing for specific capital expenditures and strategic initiatives, which creates additional scope to work with issuers to develop bond frameworks such as use of proceeds bonds (ESG bonds), which can align their financial obligations with their sustainability targets and drive transparency.

A bigger, more diverse market

Grover Burthey, Executive Vice President, Head of ESG Portfolio Management, argues that the increasing diversity of the ESG-related bond market provides a compelling lever for investors to align their ESG goals with financial performance across their entire portfolio.

Recent years have witnessed an explosion in the type of issuers looking to link debt with sustainability targets. Whereas only a few years ago, the ESG-related bond market was primarily dominated by utility companies and real-estate investment trusts (REITs), today’s market comprises issuers across retail, food and beverage, as well as other sectors of the economy. “It’s no longer just about the most carbon-intensive sectors,” says Burthey. “We are seeing a massive adoption of ESG-related debt issuance across the economy.”

Adding to that mix of corporates, there is a growing participation in sustainable bonds by sovereign issuers, including Chile, Singapore and Italy, as well as growth in the US municipal market, and even a number of US agencies. “The hope is that those who are pioneering and establishing a precedent in the market will bring others in,” he says.

At the same time, the variety of ESG-related fixed-income products has mushroomed from a modest beginning of green bonds to a wide array of instruments. Take sustainability-linked bonds, which are structurally linked to the issuer meeting specific ESG-related targets through a covenant typically linking the coupon of a bond. If the issuer falls short of the stated goals, then there is an increase in the bond’s coupon.

Additionally, unlabelled green bonds are instruments where the use of proceeds is aligned with broad environmental goals, even if the bond itself lacks a dedicated framework explaining how the proceeds will be employed.

The importance of active management

Burthey states that the growing recognition of ESG-related factors that pose a regulatory risk to companies, as well as physical risks to assets through climate change, makes it imperative for any investment-management firm to have ESG-related analysis fully incorporated in its investment approach. “As an active manager, we’re really able to zero in and match portfolios, match strategies and match market desires in terms of what clients are looking for,” he says. “Not all sustainable bonds are created equal, and investors, as well as their asset managers, need to carry out quality assessments to evaluate each framework on an individual basis.”

In practice, that means putting ESG issues at the centre of the investment process, to ensure that environmental, social and governance principles guide credit research and facilitate identification of opportunities in the market.

The result of this growth of issuers and instruments is an increasingly diverse market, which investors can use to help support their sustainable investing objectives. But it is also an increasingly complex market, which necessitates an active approach to aligning and balancing an investor’s ESG-related goals, management of ESG-related risks and financial returns.

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¹ https://www.sifma.org/wp-content/uploads/2021/07/CM-Fact-Book-2021-SIFMA.pdf

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