Interest in environmental, social and governance bonds has been rising steadily in recent years, with sustainable finance bond issuance totalling more than $1tn (£839.3bn) in 2021, compared with $28bn in 2014, when the International Capital Market Association first published the green bond principles.
To understand ESG bonds, it is first necessary to look at the overarching context of ESG investing and where ESG bonds are situated within this.
In March 2021, the EU introduced its sustainable finance disclosure regulation with the aim of increasing transparency around sustainable investment products, improving transparency on the sustainability claims made by financial market participants, and preventing greenwashing in the market.
The regulation essentially acted as a catalyst for ESG investing by requiring all financial products to be categorised as non-ESG (article six), “light” ESG (article eight) or ESG-aligned (article nine).
Unsurprisingly, this prompted a sudden re-think by fund managers around if and where they fit into the ESG space, and whether they would lose out from being qualified as non-ESG. 2021 subsequently became a record year for ESG investing, with an estimated $120bn poured into sustainable investments, more than double the $51bn in 2020.
Asset class concentration
In terms of asset class, the ESG investment landscape is currently dominated by equity funds. US investment company Capital Group’s recent research into the popularity of asset classes found that 80 per cent of global investors used equities to gain exposure to ESG.
By comparison, fixed income, private equity and emerging markets are lagging more in terms of investor activity and product offering – each for different reasons.
Firstly, private equity and emerging markets often lack sufficient ESG disclosures from companies. This means that most ESG rating providers only cover public companies in developed economies, rather than emerging markets, due to limited resources and issues around scalability.
This lack of comprehensive ESG data on private equity and emerging markets companies makes them less attractive for many ESG investors, as they simply do not have the information needed to make informed investment decisions.
With fixed income, the problem is that issuers are typically less researched. Compared to equity fund research, fund managers tend not to conduct such deep fundamental research of fixed income issuers, and their research is not often accompanied by financial modelling and the integration of ESG factors, meaning that this asset class does not traditionally lend itself to ESG-related financial products.
However, the growth in issuance of ESG bonds is challenging this perception. These bonds are a financial product that fall within fixed income securities, acting as a debt security that is tied to ESG-related goals, whether it be specific projects, or broader sustainable KPIs.
They are often appealing to companies, funds and financial institutions, as they allow organisations to showcase their ESG credentials and provide investors with a route to gaining an ESG label under the SFDR framework.
Types of ESG bonds
Today, 'ESG bonds' can cover a wide range of ESG factors, from climate change to board diversity.