Leaps and Bounds: The Surge in Sustainable Bonds
Sustainable investing may have started off in equity markets, but it is now taking flight in fixed income, too.
Much of this growth can be attributed to the switch that investors have made from non-ESG (environmental, social, governance) to ESG core bond holdings to improve the sustainability profile of their investments. Investors are doing this partly under their own steam, but also because of regulatory pressure. For example, the EU’s Sustainable Finance Disclosure Regulation (SFDR) aims to harmonize fund disclosure standards, so investors can consider and compare funds based on their ESG risks and sustainable investment objectives.
Another potential source of growth is thematic investing. Investors may want, for example, to focus on climate change by investing in bonds that score highly on the “E” of ESG. Alternatively, they may opt to concentrate on social or governance considerations.
Making an impact: green bonds
Another driver of ESG growth is impact investing: aiming to generate a measurable, sustainable outcome alongside a financial return. A common form of impact investing is via green bonds, which raise capital for projects with environmental benefits, such as those involving renewable energy, energy efficiency and wastewater management. The proceeds must be used exclusively for green projects, with the type of project declared up front.
Issuance has grown steadily since the EU’s European Investment Bank (EIB) launched the first green bond in 2007. In 2019 alone, $256 billion in green bonds was issued—only a slight reduction of the $236 billion issued in 20201. Along with multilateral entities such as the EIB, green bonds have also been issued by many national governments—starting with Poland in 2016—and companies, including utilities funding renewable energy projects.
The transparency that investors enjoy with impact reporting is a differentiating feature of green bonds. Every year, all green bonds must report the environmental metrics of the projects funded by their proceeds—a process usually overseen by a third party, such an auditor—which makes it possible for fund managers to determine the metrics of their funds as a whole. The chart below shows some examples of what a green bond fund can measure; they can also measure achievements such as green jobs created or water saved.
Green bonds can offer several other benefits. One is high quality: The average credit rating is A+2. There are also tools to help the increasing number of institutional investors that want to align their portfolios with the goal of net zero carbon emissions3. This helps to explain the increase in demand for green bonds, which has encouraged issuance.
A BlackRock study of green bonds from 40 major U.S. dollar and euro issuers, including both governments and companies, is an eye-opener. Laying to rest the myth that investors must pay extra for green bonds, the study found no pricing difference between green and non-green bonds.4
The index route: cloak of visibility
Many investors have chosen to invest in sustainable bonds through indexes. The graph below illustrates this well; look at the sudden increase in total ESG-focused exchange-traded funds (ETFs), of which the bulk is in index products. ESG assets under management (AUM) more than doubled in 2019 and again in 2020, with this acceleration continuing in 2021.
Total ESG fixed income ETF AUM ($ billion)
Index ETFs can offer a transparent, standardized approach to sustainable investing. The clearly established set of rules from being bound to an index gives investors greater visibility over which bonds they will hold in the future, and therefore what their exposure will be, in terms of credit quality and other characteristics; they also make it easier for investors to understand how their sustainability profile has improved. Sustainable index ETFs may also serve as useful building blocks for investors seeking diversification benefits and resilience during periods of markets volatility. All this is done at a low cost.
Green bond issuance looks set for a major boost in the coming years. For example, the European Commission plans to issue approximately €225 billion of green bonds by 20265. They will form a key part of the EU’s recovery fund, designed to help EU economies recover from the pandemic largely by investing in greener infrastructure. A look at the steep historical trajectory of investing in sustainable equity index products confirms our belief that the trend of using indexes to invest in sustainable fixed income is just getting started. Watch this space.
1 Source: BlackRock, December 31, 2020
2, 3, 4 Source: “Index with impact with green bonds,” BlackRock, March 2021
5 Source: “Index with Impact with green bonds,” BlackRock, March 2021
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