Identifying The Different Components of The ESG-Labelled Bond Markets

Updated: Mar 15

Discovery Path- ESG Family of Bonds: Part I

ESG-labelled or sustainability-focused bonds are becoming an important part of global fixed income markets, offering a wide range of new opportunities for active and passive investors. Experts estimate that the total volume of the sustainable debt market-including green, blue, social, and sustainable (GSS) bonds, sustainability-linked bonds (SLBs), and transition bonds-will grow by 50 per cent in 2022 to more than $1.5 trillion.

As more and more investors seek to align their portfolios with the sustainability goals outlined in the Paris Agreement or the UN Sustainable Development Goals (SDGs), it is important to understand how these bonds can help combine ESG objectives with standard risk-return objectives in portfolios. A common approach to navigating these investment options has been to rely on valuation metrics or ratings that measure the ESG impact of companies' activities and overlay the score onto assets. But a main challenge for the investors is that currently there is no clear measurement standard in the market to measure those "non-financial" returns. In a small way, however, the issuance of ESG bonds is regulated by the International Capital Markets Association (ICMA), which in 2014 established a set of voluntary guidelines to promote transparency, with the aim of unifying reporting on bond objectives and estimated impact, which are relevant for each category of ESG-labelled bonds.

There are two distinct categories of bonds that aim to promote sustainability: the Use of Proceeds bonds (UoP) and KPI-linked (Key Performance Indicator) general-purpose bonds:

  • UoP-bonds (use of proceeds bonds) fund projects with dedicated environmental and/or social benefits.

  • KPI-bonds (or general corporate purpose instruments) such as sustainability-linked bonds fund the activities of an issuer that sets explicit sustainability performance targets (SPTs) at the overall company level that are linked to the financing conditions of the bond. The coupon payments are linked to meeting their "SPTs".

§1. Environmental Bonds: Climate-related Bonds

Green Bonds

Originally issued in 2007 by multilateral and supranational lenders to finance environmentally friendly projects, corporates have started to issue green bonds in recent years. Issuances from emerging markets and high yield issuers add diversity to the green bond universe, but the market remains dominated by highly rated issuers, mainly banks and utilities. Currently, four types of "green bonds" are contemplated under the Green Bond Principles (GBP) set of voluntary process guidelines for issuing green bonds.

  • Standard Green Use of Proceeds Bond: A standard recourse-to-the-issuer debt obligation,

  • Green Revenue Bond: A non-recourse-to-the-issuer debt obligation in which the credit exposure is to the pledged cash flows of the revenue streams, fees, taxes etc. The use of proceeds may go to unrelated green projects.

  • Green Project Bond: A project bond for a single or multiple green projects for which the investor has direct exposure to the risk of the projects with or without potential recourse to the issuer.

  • Green Securitized Bond: A bond collateralized by one or more specific green projects, including covered bonds, asset-backed securities, mortgage-backed securities, and other structures; The first source of repayment is generally the cash flows of the assets.

Examples of project categories eligible for green bond issuance include renewable energy, energy efficiency, clean transportation, green buildings, wastewater management and climate change adaption.

Transition bonds

A transition bond is a bond designed to accompany the transformation of carbon-intensive, so-called "brown" sectors. These bonds are specifically aimed at companies with carbon-intensive activities that are committed to reducing their carbon emissions, but which are not a priori eligible for green bonds. The aim of these bonds is, therefore, to encourage investment in the energy transition, in line with the objectives of the Paris Agreement, by enabling a greater number of organisations to move progressively towards sustainable development models, as well as to finance projects in the fields of maritime transport, energy production or the optimisation of natural resources.

Cat Bonds

This type of financial product was developed in the United States following Hurricane Andrew in 1992. The first catastrophe bond was issued in 1996.

Catastrophe bonds are part of Insurance-Linked Securities (ILS), alternative asset classes that allow insurance and reinsurance companies to transfer risk to the financial markets and raise funds there. Eligible catastrophes are natural disasters (earthquakes, hurricanes) but pandemics are also considered.

A catastrophe bond can be structured to provide cover on an event-by-event basis or to provide global cover, i.e. exposure to several events.

§2. Environmental Bonds: Biodiversity-related Bonds

Blue Bonds

Blue bonds are probably the most niche of the sustainability bonds initiated by the issuances from the government of Seychelles in 2017, and the Nordic Investment Bank and the World Bank in 2019. They are a subset of green bonds, used specifically to finance projects related to ocean conservation and water-related initiatives. This includes managing plastic waste, but also promoting marine biodiversity by ensuring sustainable, clean and ecologically-friendly developments. Blue bonds follow the associated ICMA principles.

Rhino Impact Bonds

A rhino impact bond, or RIB, is a bond designed to promote the protection of endangered species. This financial initiative was first structured by London-based Conservation Capital in July 2019.

The idea is to transfer risk from donors to the financial markets. It is a "pay for results" bond structure. this model could revolutionise conservation funding because donors are less reluctant to spend their money when there is a result. Donors are less reluctant to spend their money when there is a tangible result and impact. This could, in fact, lead to the private sector taking a greater interest in conservation.

protection of endangered species

§3. Social Bonds

A social bond is a bond that finances projects that have a positive social impact on one or more impacts on one or more target population(s). The environmental impact of projects financed by social bonds must be positive or neutral. be positive or neutral.

Social bonds

To qualify as a social bond, the proceeds must finance or refinance projects or activities that achieve positive social outcomes and/or address a social issue. The target populations are, for example, people living below the poverty line, excluded and/or marginalised populations, vulnerable populations marginalized populations, vulnerable populations, migrants, people with disability

Issuance of social bonds is oriented by a set of voluntary guidelines – the Social Bond Principles (SBP) from ICMA – aimed toward improved disclosure and transparency in the social bond market. The SBP outline best practices also arm investors with the information necessary to evaluate the social impact of their investments.

Examples of project categories eligible for social bonds include food security and sustainable food systems, socioeconomic advancement, affordable housing, access to essential services, and affordable basic infrastructure.

§4. Sustainability related Bonds

An SDG bond or SDG linked-bond is a debt instrument whose proceeds are linked to the contribution to the United Nations Sustainable Development Goals (SDGs). The objective is to meet the need for dedicated funding to implement Agenda 30. These goals, the SDGs, encourage borrowers to improve their ESG credentials.

SDG Bonds -Sustainability bonds

These issues are senior bond transactions with the same financial and contractual terms as any other senior bond transaction. They can be unsecured, backed by the creditworthiness of the corporate or government issuer, or secured with collateral on a specific asset. When issuing a Sustainability Bond, the issuer takes the additional commitments. to allocate the proceeds to finance a combination of green and/or social projects or expenditures, defined according to a predefined set of eligibility criteria that are aligned with both the "GBP" and "SBP".(Sustainability Bond Principles) of the ICMA.

Examples of project categories eligible for sustainability bonds include those in the green and social bonds categories.

Sustainability-linked bonds (SLBs) and loans (SLLs)

The flexible structure of SLLs and SLBs enables companies from industries not traditionally considered green (or those without a portfolio of eligible green or social assets or projects) to access the sustainable finance market and a more diverse pool of investors. What matters here is the company to meet certain predefined sustainability targets which can be related to environmental or social aspects.

The proceeds from an SLL or an SLB can be used for general corporate purposes. The targets, and the key performance indicators on which they are based, are generally benchmarked either internally to the company’s past performance and/or externally to science-based targets or other independent assessments such as an ESG score.

For SLLs, the interest rate of the loan may increase if the borrower fails to achieve the agreed-upon sustainability performance target and vice versa. Revolving credit facilities can also be included in this category. In an SLB agreement, the bond’s coupon rate will increase, or the issuer may pay a penalty when the bond matures if it fails to achieve the sustainability or ESG objectives.

ESG-labelled and sustainability-focused bonds are becoming an important part of global fixed income markets, offering a wide range of new opportunities for active and passive investors.

Some main challenges to consider

The rapid growth in the issuance of ESG-labelled securities by a wider variety of companies than ever before makes it essential to use a disciplined framework to assess them. Investors need to apply a materiality test to the use of the proceeds, analysing the specifics of each bond's structure and understanding how it supports the overall sustainability strategy of the issuing company. In this way, they will be able to address the following key challenges:

Greenwashing risk: The act of 'greenwashing', or issuers misrepresenting the positive environmental impact of bond proceeds, is an ongoing challenge that investors can face. This can occur because of the relatively broad criteria for what constitutes a green bond and the lack of formal issuing guidelines in many emerging markets. Issuer risk: There is an increased risk of liquidity and over-concentration on certain issuers, sectors or regions. In addition, like any other bond, they carry a risk of default, which varies according to the underlying credit quality of the issuer.

The bonds whose terms merely gesture toward environmental and social factors but have no real impact are less likely to perform well over the long term-making a bond's design as important as its price.