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Labelled bonds: the green, the bad and the ugly

Undaunted by the ESG challenge
Introducing the series
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This is the fourth article in our new series, which looks at environmental, social and governance issues in the fixed income space.
Our unfixed approach
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In the spirit of (un)fixed income – bold, innovative and flexible – we start each piece with an ESG challenge before flipping it on its head.
Answering the big questions
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The aim of this series? To explore how investors can successfully navigate some of the greatest issues of our age.

We started this article series with one Chancellor of the Exchequer in the news. We’ll wrap it up with another.

In the run up to the COP26 summit last autumn, Rishi Sunak’s Treasury made headlines by launching the UK’s first ever green gilt – a twelve-year bond which will mature on 31 July 2033. It will be used to finance clean transport, energy efficiency, and pollution prevention, among other projects.

This is reflective of a wider trend that is gaining momentum in the industry. It’s one that the teams at Invesco are watching closely.

Labelled bonds: a growing market

ESG labelled bonds are a growing market, as shown in Figure 1, and they have some clear benefits for investors. They allow them to access comparable financial returns while aligning their portfolios with their values or ESG mandate requirements.

They can also help mitigate against climate related risks, and Tom Hemmant (Fixed Interest Fund Manager) flags the fact that they can be a ‘good indicator that a company has opportunities to deploy capital expenditure in green activities’. 

Figure 1: Huge growth in green and sustainable bond issuance

Source: BloombergNEF. Data as at 24 March 2021.

While sustainability bonds can help investors green their portfolios, they also bring their own set of challenges and complexities. As flagged by Sam Morton (Head of European Investment Grade Research) in a recent whitepaper, there are certain differentials that need to be addressed:

Usual integrated ESG analysis (examining an issuer’s ESG characteristics relative to sector peers and deriving an overall A-E rating with trend) does not fully address sustainability bonds because of the way these securities target specific projects.

‘Although unlikely, an A-rated ESG issuer could theoretically issue a low-quality sustainability bond, and an E-rated ESG issuer could issue a high-quality sustainability bond’, Sam Morton adds.

Sustainability-linked bonds: a different layer of complexity

Meanwhile, sustainability-linked bonds (whose proceeds are not allocated to specific projects, but used for general corporate purposes) avoid the issue outlined above, but bring a separate layer of complexity to the table.

For clarification, these are debt instruments whose financial characteristics change depending on whether the issuer achieves predefined sustainability objectives. Often, it is the coupon that will change, increasing by a certain amount each year if the issuer misses its target.

The lack of specificity associated with these bonds leaves investors reliant on the overall ESG credentials of the issuer. They need to decide whether they value the achievement of these KPIs, the financial consequences, and how these will be reported to investors.

Matching risk and reward

The two examples in this article provide just a flavour of the considerations at play. What’s crucial is that investors closely monitor these risks as they evolve.

At Invesco, we believe that having well-resourced and experienced credit and investment teams is crucial to this process. They look to ensure that credit spreads adequately reflect downside risks, with ‘at risk’ names avoided where this is not the case.

Discover (un)fixed income

We know investors are living through an unprecedented period of market disruption and volatility. As we face these new realities, we think taking an unfixed approach to fixed income is an advantage.

From active to passive, from mainstream to innovative, we have the expertise, the strategies and the flexibility needed to match your objectives as markets evolve.

Investment risks

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