Sustainable finance builds unstoppable momentum
With sovereign ESG bonds passing a clear inflection point, sustainability-linked bonds seeing notable growth and acceptance, and social bonds catapulted forward by a key borrower — the European Union (EU) — that is also poised to boost the green bonds market with an unprecedented €250bn programme, sustainable debt capital markets are reaching a new peak of activity across the capital structure from every issuer and credit type. So what’s driving the current boom and what will follow it?
Once a marginal 1%-2% of new fixed income sales, ESG debt offerings have now reached a more substantial share of as much as 10%, according to Moody’s ESG Solutions. The landmark $1tr a year target for green bond sales long called for by NGO Climate Bonds Initiative to meet the global need for climate change adaptation and mitigation spending is now moving into reach.
Overall, new issue volumes have risen from $50bn in 2015 to more than $500bn in 2020, Morgan Stanley data shows. 2021 has ramped up this exponential rise further with an increase of 100% to date over the same period last year.
“ESG is now a major focus for all key stakeholders in the market and will remain a central theme for years to come,” says Alexander Menounos, managing director, head of EMEA DCM and global co-head of IG syndicate at Morgan Stanley.
Morgan Stanley sees the take-off in ESG debt picking up further from here. “Issuance has more than doubled this year and we expect the pace of supply to continue to accelerate,” Menounos adds.
Importantly, growth has been accompanied by a significant broadening of the market. “In recent months we have witnessed a greater diversification with respect to sectors, issuers and instruments,” he affirms.
Besides investment grade credits, high yield borrowers too (both from developed and emerging economies) are increasingly active in multiple formats. In addition, the product range has soared far beyond traditional senior bonds: ESG debt investors have now also bought corporate hybrids, financial subordinated and senior non-preferred bonds, convertible bonds, and even securitizations using some form of use-of-proceeds structure. Sustainability-linked securitizations are on the way too, while sales of convertible sustainability-linked bonds (SLBs) have also begun.
While not all investors are equally comfortable with each of these innovations, a significant proportion of buyers are open to less standard ESG debt. If they are comfortable that the borrower’s core strategy (and the instrument’s KPIs, if included) meets their criteria, they gain access to higher returning debt with the potential to enhance their returns.
While ESG debt has always featured sporadic instances of higher-return issues (generally from lower rated borrowers), this expansion across the capital structure marks a key development in building the market out.
“Investors are keen to see the market evolve and develop in some of the higher yielding formats and instruments. They want to see the market develop across the credit quality and subordination spectrum. They don’t want to miss out on higher yielding opportunities,” judges Menounos.
Fundamental for investors
ESG debt’s new traction coincides with ESG considerations having become mainstream for both equity and fixed income investors — and increasingly influential. “ESG is a fundamental component of how you invest,” says Navindu Katugampola, global head of sustainability at Morgan Stanley Investment Management (MSIM).
“Questions of sustainability and the impact of funds are inherent in managing risk and assessing valuation,” he affirms, noting that assessing which companies are best placed to benefit from recovery across sectors, industries and countries is a potential source of alpha.
“If credit quality, returns and liquidity have so far been the three most important investment criteria within each sector and product, ESG will surely be the fourth,” adds Menounos.
He notes how internal or external ESG ratings are already as important to credit ratings for many investors. “And these drive investment mandates, they drive credit lines and they drive overall sector and issuer-specific investment appetite.”
What investors particularly appreciate about ESG debt is the additional transparency over and information on issuers’ business models and strategies they provide, as well as opportunities to engage, Katugampola argues. “Essentially you are performing a sustainability deep dive with issuers when they come to market.”
However, MSIM insists that it is not a forced buyer, even though it holds ESG debt in its portfolios — particularly those under Article 9 of the EU Sustainable Finance Disclosure Regulation (SFDR). “We like the instruments, but if they come significantly tight we may choose to buy regular bonds instead,” Katugampola says, though the firm is open to buying bonds priced with a greenium if it expects them to perform in the secondary market.
MSIM believes that all ESG debt “has its place” and is open to both use-of-proceeds and SLB structures, Katugampola says. But while it welcomes the market’s acceleration and broadening, it regards bond labels as “in some ways irrelevant”. “It’s more pertinent to look under the hood. These bonds only have credibility if they help improve the issuer’s strategy.”
Ultimately, greater disclosure requirements of issuers or access to their data in an on-demand way may make the labelling of ESG bonds redundant. But this could still be a decade away, Katugampola cautions.
In the meantime he expects the instruments to continue their expansion and to serve as a useful part of issuers’ toolkits. Over this period he anticipates a divergence in companies’ cost of capital that reflects the robustness of their ESG strategies and their capacity to manage their sustainability risks.
Divergence in the availability of capital from investors for some sectors is likely to exacerbate this and add to the volatility of their bond spreads and equity prices.
ESG’s growing centrality for investors makes it central too for issuers seeking to access their capital. “ESG is now becoming critically important for issuers, who need to align their funding strategy to the company ESG strategy and demonstrate commitment to sustainability,” Menounos notes.
“Most of our work is to try and advise C-suites around the transition, around building a credible transition strategy, around effectively capturing the new opportunities, and using the capital markets to precisely highlight those initiatives and commitments,” agrees Maxime Stevignon, head of fixed income capital markets for France, Belux and Switzerland at Morgan Stanley.
Stevignon hails the shift from companies’ earlier “tactical” engagement with ESG. “The shift from tactical to strategic is absolutely paramount in what we’ve seen over the past 18 months, and I’ve been quite staggered by the speed at which it has happened. We were discussing it with clients three years ago, and no one was really expecting it would change so quickly.”
This new emphasis has created a strong link between sustainability strategy and market access or cost of capital. “If you don’t have a credible ESG strategy, there is a real risk of being left behind. It’s not merely a case of extracting a small pricing advantage — it may soon have a material impact on depth and breadth of investor audience,” Menounos emphasises.
At high-emissions companies, this link is now clear all the way to the top. “This is something that in certain sectors is recognised and understood at the C-suite and board level,” Stevignon notes.
This creates opportunities for what he terms “ESG enablers” to access investor demand while communicating their leadership. He cites the recent landmark social hybrid bond by EDF, the first such corporate offering in euros. Already an active green bond and green convertible bond issuer, the French utility created a social bond framework to highlight the second pillar of its ESG strategy — social responsibility.
Proceeds will fund expenditure with SMEs in regions across Europe and the UK to upgrade the company’s nuclear power facilities and develop new clean energy technologies.
Social bonds are also in focus in the sovereign, supranational and agency (SSA) sector. This follows the EU’s near-€90bn endorsement of the product through its SURE ‘Support to mitigate Unemployment Risks in an Emergency’ programme — an unprecedented addition of supply to the sector.
Although very few sovereigns have offered pure social bonds in their own names, agencies such as France’s Cades (Caisse d’Amortissement de la Dette Sociale) have already raised substantial funding in the social format. Recently, the sub-sovereign Communaute Francaise de Belgique (CFB) also funded education and sports expenditures through a debut social bond.
“It will be quite key to see how the sovereigns, particularly those with established ESG programmes, look to proceed on the social bond front over the next year or so,” says Ben Adubi, head of SSA syndicate EMEA at Morgan Stanley.
Social bonds raise even more questions than their green bond counterparts over use-of-proceeds and transparency. “Clearly those two elements are more challenging to define and measure on the social side,” adds Adubi. “So they require greater attention — particularly around the transparency on the impact and outcome of social bond programmes.”
One important question is whether other SSA borrowers can adopt best practice from the EU SURE framework. But a more pivotal issue may be long-term commitment to the product.
“A lot of the social issuance has been skewed towards the effects of Covid,” says Adubi. “The question of whether these short-dated, temporary issuances under social bond frameworks will be there in the long term?” He cautions that “sovereigns and issuers of that category of bonds should be mindful, particularly where they already have large green bond funding programmes as a starting point — we know that investors value consistency.”
(See Sovereign box in the accompanying Expansion of Sustainable Finance chapter for further discussion)
HY heating up
The increasing involvement of high yield issuers in ESG debt stands out as a key sign of the market’s growing maturity. “It has been a real sea change. There was a lot of discussion last year around when the wave of issuance was going to come, how it was going to come and what it was going to look like — and now it’s here,” reports Jane Bradshaw, co-head of leveraged finance capital markets EMEA at Morgan Stanley.
Although the bulk of this year’s high yield ESG new issues have been for industrial, transport and real estate companies, a broader array of sectors is also showing appetite to access this form of investor demand. “Essentially every conversation we are having, whether sponsor-owned business or corporate and no matter what sector, is including a discussion of both ESG broadly and the benefits or potential benefits on SLBs and green bonds,” adds Bradshaw. Given all of that, I think the growth is going to continue apace and that sector list will certainly start to grow.”
The increasing level of activity is also helping to draw further issuers. “Having a bunch of concrete examples out in the market for prospective issuers to look at and to understand in terms of what others have done and what they as issuers could do is really helpful,” she judges.
Greater clarity on pricing benefits may also bring more new issue flow. “If we are able to evidence to issuers that there is a concrete pricing benefit in addition to the broader benefits of doing a positive ESG trade, that would be helpful as well.”
A further significant driver in the high yield sector is the influence of private equity (PE) owners. As underscored by EQT’s landmark gender-linked SLB, many PE firms put great emphasis on ESG. “For some of the private equity sponsors ESG is a really important internal policy matter and a lot of the firms now have their own frameworks,” Bradshaw notes, adding that these can be “quite robust”.
In turn, this leads to PE owners encouraging their portfolio companies to pursue ESG issuance “not just for purposes of price and yield”.
Although high yield names account for a higher share of SLB volume (estimated by Moody’s ESG Solutions at around 25%) than in green bonds, Bradshaw sees the longer established format continuing to attract high yield issuers too. “There has been a pretty decent mix in the year to date and I would expect that to continue. But I wouldn’t expect high yield is just going to go down the path of SLBs with use-of-proceeds bonds forgotten about.”
Several factors could lead to greater high yield activity in SLBs, however. One is the capacity constraint of companies lacking green or social expenditures for use-of-proceeds bonds to fund, which SLBs’ use for ‘general corporate purposes’ sidesteps. Another is the significant burden of green or social bond reporting for smaller companies.
As the market deepens, any indication of one instrument having a pricing benefit over the other — perhaps because more fund types can buy it — is also likely to influence the skew within overall volume.
FIG finding traction
Further high yielding ESG debt is also starting to emerge from the financial institutions (FIG) sector where banks have begun issuing subordinated capital in green and social format, along with green senior non-preferred (SNP) debt — though some regulatory uncertainty remains over these products and bank SLBs, of which only a solitary issue from an untypical German credit has yet been sold.
“In the MREL space — senior preferred and non-preferred — we have reached a stage of maturity where European banks can voluntarily choose to issue the majority or even the entirety of their funding needs in ESG-compliant formats, which wasn’t the case before because it was a nascent asset class,” notes Charles-Antoine Dozin, head of capital structuring at Morgan Stanley.
Increasingly, the only limits on banks’ senior ESG issuance are their capacity to originate green and social assets and their need for MREL (minimum requirements for own funds and eligible liabilities)-qualifying debt. “The capacity constraint is firmly on the asset side,” Dozin comments.
As a result, sales of ESG bank capital are also picking up. While only one bank — Spain’s BBVA — has issued AT1 debt (the most deeply subordinated layer of banks’ quasi-equity) in green format, Tier 2 sales are finding traction. Recently Spain’s newly-merged Caixabank introduced Tier 2 social bonds, building on green Tier 2 offerings by a number of issuers.
“Although it has been slower, we are seeing the take-up in the capital space increase and a decent level of activity in the tier two space,” Dozin comments.
(See accompanying regulation chapter for discussion of regulatory issues around ESG bank capital.)
A further aspect of capacity constraints has been that some banks have opted to confine all their ESG debt issuance to a single asset class, such as SNP. “It’s a matter of consistency and coherence,” says Dozin. “The rationale is ‘if we’re going to be issuing green but we’re going to be limited in terms of volumes we can raise, we might as well do it in one asset class’. This facilitates comparisons, benchmarking pricing and liquidity, and makes the process more consistent.”
Even so, in the longer term at least some banks are looking to commit all of their funding to green and social instruments. “There’s already a couple of institutions that have announced intentions to meet all their requirements and funding needs in green and social format,” Dozin notes.
He cites de Volksbank of the Netherlands as an example of a lender taking this stance.
(See accompanying SLB chapter for discussion of the challenges of bank SLBs.)
Currencies coming into view
Observers could be forgiven for assuming that ESG debt is a euro-only area, so dominant is the European single currency in recent deal flow — a phenomenon underpinned by the European Central Bank (ECB)’s role as the key buyer of much ESG debt in the currency and which the EU’s gargantuan green bonds programme is likely to exacerbate.
But this primacy does not mean that other currencies have no activity. Within Europe alone, the Norwegian kroner, sterling, Swedish kronor and Swiss franc sectors have all seen flows of corporate and financial ESG new issues. So too have the US and, to a lesser extent, Japanese domestic markets — including from municipal and other sub-sovereign names.
Pockets of activity have been seen in all other regional markets — Asia-Pacific, Middle East/Africa and Latin America — too. This includes ESG debt sales by foreign credits, such as supranationals into Australia’s Kangaroo bond market and corporates into Taiwan’s Formosa sector.
This picture suggests that the broad trajectory is likely to be the same for all markets. As local investor demand builds, even lagging areas such as some Asian countries and other emerging markets will eventually see more sustained ESG debt supply too.
“In years to come, ESG is likely to be relevant across all currencies,” affirms Menounos. While today’s core ESG debt investors in countries such as France and the Netherlands are typically euro-based or have most investment capacity in the currency, “it’s only a matter of time before others catch up”.