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SRI bonds: haggling over price comes into the open

By Lewis McLellan
19 Jun 2018

Some public sector borrowers want to see green bonds and the growing rainbow of social and sustainability deals regularly and reliably being priced more tightly than their conventional bonds. The ambition is to set an incentive that will spread through the market and encourage ethical spending. But some worry that setting the pricing bar higher for SRI bonds than vanilla as a matter of course could deter investors. Lewis McLellan reports.

Marcin Bill, a senior financial officer at the International Finance Corp in Washington DC, believes that a pricing differential is the next stage for the socially responsible investment (SRI) bond market. “In my mind, and in time, supranationals should lead the way in attempting to price SRI bonds inside their conventional curves in the primary market, should the secondary market outperformance justify it and be expected,” he says. “I would like to see this become the norm, and supranationals are in position to lead the way, given our mandate and ambition to create markets.”

A World Bank spokesperson agrees: “We share this view. We believe it’s reasonable for labelled bonds to be priced tighter than conventional bonds, given the added costs to the issuer of impact tracking and reporting.”

SSA Social bondsInvestors, perhaps predictably, take a different view of green bonds. “The recourse of a green bond is identical to that of a conventional bond and, as such, there is no risk/return justification for paying up,” says Johanna Köb, head of responsible investment at Zurich Insurance in Switzerland. “We have very clear guidance for our portfolio managers: go for the sustainable version when they’re both available, but not if there is more than a technical variation in price based on market conditions.”

Alban de Fay, head of SRI processes at Amundi, says: “We buy green bonds, yes. But not at any price. Our conviction is that a green bond is a regular bond and that it should be priced on the credit quality of the issuer, regardless of the level of transparency it offers.”

The debate over whether SRI bonds should be priced more tightly than conventional bonds has been raging since the market began. It hinges on two points. First, should issuers be compensated by a better cost of funds for the additional reporting costs of providing transparency on the impact of their use of proceeds? Second, do SRI bonds perform better in the secondary market than their vanilla counterparts and, if so, should this be reflected in the primary market price?

Bigger barrier

Perhaps the single most important factor affecting European bond prices for the past three years has been the European Central Bank’s €2.5tr asset purchase programme. While new data, and political flare-ups, can change expectations in a heartbeat, most believe that quantitative easing will stop in September 2018.

SSA RabobankBy the time the ECB has finally retired its €30bn monthly crutch, the market is likely to have undergone a repricing. With credit spreads almost certain to widen, Crispijn Kooijmans, head of public sector origination at Rabobank in Utrecht, says this could have an impact on a putative green pricing differential. “It will be interesting to see the difference between SRI and regular bonds in a market with wider spreads and new issue premiums,” says Kooijmans. “Printing through secondary levels is a bigger mental barrier than printing through hypothetical primary levels, so printing with a smaller new issue premium is easier than going through the curve.”

Marilyn Ceci, JP Morgan’s head of green bonds in New York, agrees: “If spreads widen, it may be easier to see the effect [of SRI bonds lessening new issue premiums].”

De Fay is less sure, believing that green bonds and conventional bonds will experience the same effects, moving wider in tandem.

What’s fair?

Investors maintain that participating in the green bond market and its offshoots holds additional costs for them, too. De Fay says: “We have to hire green bond analysts in addition to credit analysts. We may have to pay an additional data provider. We provide deeper reporting on the impact. If we pass those costs on to clients and the yield is cut by issuers, there won’t be much left for the final investor. Why should the final investor bear the final cost?”

Who has the power in the transaction will determine who will have the advantage.

While investors can express their views on pricing by passing over deals they deem too expensive, as both Köb and de Fay say they have done in the past few months, it would seem the balance of power rests with the issuer.

The well-stuffed books for green, social or sustainable bonds offering the skinniest of new issue premiums indicate a truth conceded by all investors: supply and demand are out of kilter. There are simply not enough green bonds hitting the market to fill the portfolios of the throngs of asset managers who have set up dedicated green portfolios. Mechanically, green bonds sell to a larger universe; dedicated green investors only buy SRI bonds, but conventional investors also buy green bonds.

Jens Hellerup, head of funding and investor relations at the Nordic Investment Bank, says NIB’s recent green bond came with a new issue premium of between 0bp and 1bp. While he pointed out that, in exceptionally good market conditions, even a conventional deal could come flat to the curve, almost half of the 50 investors in the bond were new to NIB paper and many would not otherwise have participated in the deal, because they run dedicated green portfolios. 

Mizuho argued in a report in late February that green bonds were more expensive for investors than conventional bonds, particularly in euros, although the effect was also observable in dollars. In the secondary market, green bonds in euros tended to trade between 1.5bp and 3.4bp richer than vanilla bonds, though for the most statistically significant issuers, the spread was between 1.5bp and 2bp.

Not everyone agrees that green bonds trade more tightly than conventional bonds. De Fay says that research on the secondary market for green bonds is invalid because of the small sample sizes and technical factors muddying the issue. “It’s true that green bonds sometimes trade tighter in the secondary market than conventional bonds but the market is so small that it’s hard to come to a clear conclusion from so few examples,” he says. “When you look more closely, you can see that the pricing difference is linked to technical factors, particularly sizing. As yet, the evidence is not there that green bonds are consistently more expensive because of the green label [rather than technical factors].”

What’s right?

Whether or not SRI bonds price inside their conventional counterparts, the question remains: is that a desirable state of affairs?

Köb does not deny that, as the demand for SRI paper grows, the supply-demand logic “comes into play”, but says that “if the dynamic is exploited, we will see the green investor base bifurcate between those who remain firm to their economics and those who are from a more concessionary part of the spectrum and are forced by their mandates to buy green paper.”

The largest pools of potential investment are in the former category, she says, and it would do tremendous damage to the green bond market if mainstream investors were put off by smaller returns.

SSA SRISome, like Bill at the IFC, would like “an ESG market where a corporation, when deciding on the format of financing, chooses a thematic bond as a cheaper vehicle and hence that corporation would be in a position to opt for projects that are perhaps more expensive but supportive of the environmental, social or governance agenda”.

In some ways, the difference of opinion is an extension of the different approaches of banks’ debt capital markets and syndicate desks. Margret Hess, DCM origination banker at DZ Bank, says: “We’re looking for added value for issuers. If we can get tighter pricing, they can pass on that funding advantage and it encourages them to pursue sustainable projects. Without a pricing advantage, it’s tougher to persuade people of the advantage.”

Ralph Ockert, head of syndicate at DZ Bank, has a different set of considerations. “I understand the desire for tighter pricing, but I would rather not see too much power on one side. If the pricing expectations of investors and issuers are markedly different, it becomes difficult to execute deals smoothly.”

Although some financial incentive for issuers might spur them to fund socially responsible projects, some believe it could cause more harm than good. Many believe, like de Fay, that tax advantages or other governmental measures would be a better way to encourage a change in spending habits. Investors have worked hard to send a message that impact investment does not mean sacrificing returns. However, if power remains with the issuers, perhaps this will be proved wrong.    

By Lewis McLellan
19 Jun 2018