New diversity in green bonds may offer fertile ground for investors
The green bonds sector is changing. Years of powerful growth have not only brought it into the mainstream but have also delivered a richer, more varied universe for investors. As the world seeks the funds that will finance the energy transition and the road to net zero, we think this diversification will continue and evolve, rewarding those with the know-how to spot potential wrinkles as the opportunity set expands.
Green bonds emerged as a mechanism to drive capital towards projects or businesses that had at their heart the drive to improve environmental outcomes. Initially, and unsurprisingly, much of the activity was government related. When AXA IM launched its own green bond strategy in 2015, the market was dominated by quasi-sovereign issuance and stood at about $50bn. In 2022, the landscape is very different.
This is now a $1trn marketplace with the split of sovereign-related to credit issuers at about 50/50. Over the last seven years a host of new players have joined the field – the number of issuers now is close to 600. Banks have played a key role and continue to do so, but we have also seen a substantial contribution from many corporate sectors such as real estate, telecoms, autos, chemicals and consumer goods. More and more sectors are seeing the sense of investing in the transition and seeking funds that can help them reduce their exposure to climate change – or maybe adapt to the effects that a transitioning economy may have on demand.
Sovereigns meanwhile, that old bulwark of the market, have continued to issue green bonds and new countries join the fray every year. After the UK, Italy and Spain in 2021, Denmark, Canada or Austria have been recent additions as the sustained momentum around net zero helps to drive investment in the sovereign and corporate sectors.
Greater breadth to the market
And in that widening of the universe, we have also seen a greater breadth of risk profiles on offer. High quality issuers remain a core part of the market, of course, but on the credit side we have seen more subordination from banks and corporates that have issued Tier 2 and hybrid debt.
There have also been some pure high-yield (HY) players coming to the market. This was difficult for them initially. They tend to be smaller, which amplifies the effect of the additional costs attached to issuing green bonds for the first time. However, this has been a steady dynamic, and right now HY accounts for about 10% of the wider universe – made up of pure HY and subordinated debt from investment grade issuers which is rated as HY.
Another important change over the years has been the emergence of an appetite for green bonds in developing markets. China has clearly been a huge story, with estimates that issuance in 2022 could breach the $100bn mark. This trend has prompted asset managers like AXA IM to look very carefully at the sometimes complex nature of the issuance. China has an important role to play in the transition to a net zero economy, and our general view is that major investors should promote a progressive harmonisation of global green bond standards, and in the meantime focus on close analysis of each bond on its own merits.
Much of issuance in China been on the onshore market, perhaps discouraging to foreign investors – but there remains substantial issuance in dollars and euros. In short, not every green bond issued in China is eligible according to our framework, but there are credible instruments and initiatives that investors can support.
Growing opportunities in emerging markets
And the emerging markets story is not just about China. India, Indonesia, Chile and others are getting in on the act, and we have seen activity at both sovereign and corporate level. We firmly expect this to gather momentum over the years to come. We also think this constitutes a potential opportunity for anyone committed to an environmental strategy as it helps drive the transition in markets that may be playing catch-up, spreading financing for lower-carbon projects and companies to places where the net impact can be greater than in more developed markets.
The practical, transition-related benefits aside, we believe this potential for allocating capital across the developing world may bring clear diversification benefits for portfolio construction. That is the case in terms of risk profiles and potential yield pick-up compared to similarly rated European issuance, underpinning the case for pursuing a more dynamic strategy in green bonds – one that seeks to seize this niche-but-growing opportunity set in the market.
The China example is a good warning for green bond investors that can be applied more widely – not all issuance is created equal. There are risks in this market that may not be visible elsewhere. Is a project actually green? Does it form part of a wider corporate strategy that is positively aligned with environmental goals? How much of the funds raised could end up being used for ‘other’ purposes?
As the market expands, and breaks new ground, we think we have a responsibility to maintain the integrity of our strategies. Caution is crucial. There is no guarantee that every new issue is genuinely and verifiably ‘green’, and part of the role of a truly responsible and active investor is to carefully interrogate prospective holdings.
Investors need to be diligent
The growth of green bonds is a healthy development, and it is funnelling money to initiatives that will help drive the energy transition, but it also opens up the prospect of companies or countries attempting to come to market with proposals that lie on (or beyond) the edge of acceptability.
We rigorously apply our proprietary green bonds framework as we go about building portfolios, and it is noticeable that at the same time as we diversify holdings into this universe, the proportion of issuance that we deem to fall short of our standards is also growing. And it’s not only true for credit issuers. We decided not to invest in more than one recent sovereign issuance as we concluded the projects earmarked to receive financing were not fossil-free. We see clear and material reputational, and possibly financial, risks for investors who fail to exercise great care in selecting green bond assets. We have observed that green bonds from issuers experiencing environmental, social and governance (ESG)-related controversies tend to suffer more than the conventional equivalent.
With diversification comes the need for diligence. This is a $1trn market that has burst into the investment world as we all seek to build sustainable future economies. Its development into a truly expansive universe should bring great benefits to the planet – and to active, responsible investors with the wherewithal to understand and navigate the new landscape.
Our Green Bonds Strategy
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