What are green bonds? What are sustainable bonds? How can I reliably assess a single bond or a fund that operates under the label of sustainable bonds in order to meet my investment needs as a private or institutional investor? Sandro Grimm, Head of the Swiss Franc Fixed Income team, has received numerous awards from rating agencies for the quality and performance of his fund management and, together with Portfolio Manager Christopher Radler, provides information as an expert in the market of sustainable bonds and the Swiss market of green bonds.
The universe of sustainable bonds consists of four main types of bonds
The term "ESG bonds" is now used interchangeably for sustainable bonds. Investors are confronted with four types of sustainable bonds.
- Green bonds
- Social bonds
- Sustainable bonds
- Sustainable-linked bonds
How can these different types of bonds be classified so that an investor can make the right investment decision?
These are traditional bonds that the issuer invests exclusively in projects that protect or reduce the impact on the environment and climate. Examples of such projects are climate neutrality, electromobility, investments in energy-efficient technologies as well as circular economy projects. The structure and risk profile of a green bond are similar to that of a conventional bond from the same issuer, i.e. the expected return. The biggest issuers are from the public sector. Other major issuers come from the financial sector or the energy supply sector.
Green bonds are not the only way to provide money for sustainable financing. Social bonds finance projects with social purposes. Many of the coronavirus-related measures were financed with social bonds in 2020. Their issue volume multiplied. At the end of 2020, the EU Commission decided to finance its labor market programme SURE (Support to mitigate Unemployment Risks in an Emergency) via social bonds, which has made the EU the largest social bond issuer in the world.
The proceeds of the bond are used by the issuer for a sustainable project, which can consist of a mix of green and social purposes or is characterised by a contribution to the achievement of at least one of the UN Sustainable Development Goals.
In the case of sustainable-linked bonds, the issue proceeds of the issuer are not used specifically for projects, but for general corporate purposes, which serve to track identified sustainable KPIs (key performance indicators) and sustainability performance targets (SPTs). Target achievement must be presented by the issuer at the specified time and be verifiable for investors. Penalties are usually defined in case the targets are not achieved, for example in the form of a coupon increase. The following are used as KPIs, for example:
- The CO2 emissions or a defined path to cut CO2 emissions
- The proportion of recycled waste and an improvement in the recycling rate
- Social factors such as the proportion of women among managers.
In addition, there are now instruments known as transition bonds. These bonds also give the big polluters among companies and institutions access to financing with the sustainability label. The requirement is that they commit to the principles of the International Capital Market Association (ICMA), which are today the most common market standard for green bonds (see below). For institutional investors, this transparency is sufficient and their acceptance of such transition bonds is increasing accordingly. Generally, they are not consistent with the ethical and ecological understanding of private investors today.
Demand is boosting supply
Globally, the issue of sustainable bonds increased rapidly through to the end of 2021. The chart below shows how strong this increase was. In 2022, issue activity remained subdued due to the difficult situation on the bond markets. A major theme for these green and social issues by companies as well as national and supranational institutions can be seen in the Herculian issuance activity of the 21st century: the financing of the international economy towards dealing with climate change. The coronavirus pandemic also provided significant impetus for the financing of projects in the form of social bonds. The total amount of outstanding bonds worldwide with the sustainability label is published as part of the market statistics of the Climate Bonds Initiative. At the end of Q3 2022, this totalled up to around USD 2 trilllion. That sounds like a large amount. However, the sustainable share of the total global outstanding bond volume is only around 3% – but the trend is rising sharply from a low level. Green bonds are considered catalysts for the global economy's shift to lower carbon consumption. Companies and states that miss this transformation will become economic losers in the medium term. Financing sustainable growth, on the other hand, promises yields that are roughly in line with the market. On average, green bonds pay a slightly lower yield. This is referred to as the greenium.