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Sustainability-linked fixed income – Beyond green bonds

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BNP Paribas Asset Management
 

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Issuance of green bonds began more than 10 years ago in response to (institutional) investor concerns about climate change and its political and economic implications. [1] They have become a major pillar of an asset class of sustainability-linked fixed income securities that continues to grow.

Felipe Gordillo and Xuan Sheng Ou Yong discuss three recent innovations in thematic fixed income investing and highlight regulatory support for sustainability-linked assets.

Social bonds get a boost from the pandemic

The market in social bonds took off in 2020 due to a sharp rise in issuance by corporates and governments in support of efforts to tackle the pandemic. While in 2019, social bonds amounted to some 5% of total thematic bonds, volume had risen to account for a third of the segment by the end of 2020.

Global issuance of social bonds – debt tied to causes such as providing unemployment support or funding medical research – grew by more than five times in 2020 relative to 2019, outpacing green bonds’ growth across the two years.

Volumes were bolstered by the presence of select mega-issuers, particularly in Europe, including the EU’s EUR 100 billion Support to mitigate Unemployment Risks in an Emergency (SURE) programme. This aims to give member states the financial means to fight the negative economic and social consequences of the coronavirus outbreak.

Other government-backed programmes, for example, have turned to issuing debt to bolster unemployment initiatives, helping preserve jobs amid the severe economic shock.

Amid the popularity of social bonds, it should be noted that not all are created equal. There is a risk of ‘social washing’ – issuers may say proceeds will go to certain causes and then direct funds elsewhere, for example, to areas that are not maximising their positive impact on society.

We expect issuers to manage and mitigate the side-effects of their social bond projects and to ensure that there is a clear and transparent mechanism for project selection and reporting on the social benefits. BNP Paribas Asset Management asks issuers to provide an impact report on these benefits. We aim to engage with the issuer on the challenges and opportunities of their social framework.

Financing decommissioning in oil & gas

A market is emerging for bond issues by highly CO2 intensive companies. At first glance, this could appear contrary to the philosophy of the segment, which might be expected to be focused on climate change adaptation and mitigation, but the idea is to help companies finance plans to deal with stranded assets as they decarbonise.

Decommissioning infrastructure and assets which have or are due to become superfluous in the transition to a greener, more equitable and more sustainable economy can be complex and costly. These efforts are often related to fossil fuels. Oil and gas companies, for example, are legally obliged to decommission assets at the end of their productive lives in accordance with environmental law.

As an example, the proceeds might be used to build a photovoltaic power plant producing renewable energy for a desalination project as part of a project to replace a thermal desalination plant, improving local air quality and reducing greenhouse gas emissions.

Bonds could also be used to finance the liabilities tied to stranded assets and obsolete assets or efforts to deal with hazardous materials or returning the land to the original condition and restoring vegetation. Financial guarantees posted for such work could be financed with bonds.

Tying bond rewards to environmental performance

So-called KPI-linked bonds have appeared where the coupon paid is tied to key performance indicators. The bond’s annual pay-out rises as the issuer fails to deliver on sustainability targets, creating an incentive for the issuer to meet sustainability targets.

An issuer could, for example, aim to cut the carbon intensity of its pulp & paper production or link the KPI (key-performance indicator) to installed capacity in renewable energy sources. It should be clear that fewer targets allow for a more focused sustainability story, which can be easier to communicate to investors. However, it is also possible for an issuer to combine different aspects of sustainability into one solution.

Central bankers come to the aid

Sustainability-linked bonds have been boosted by regulatory support. For example, the European Central Bank has committed to reviewing its asset purchase programme to assess the ‘green-ness’ of bond buying and the possibility to support green bonds.

Already, the ECB accepts bonds with coupon structures linked to certain sustainability performance targets as eligible as collateral for Eurosystem credit operations and Eurosystem outright purchases for monetary policy purposes.

The coupons must be linked to a performance target referring to one or more of the environmental objectives set out in the EU Taxonomy and/or to one or more of the UN Sustainable Development Goals (SDGs) relating to climate change or environmental degradation. This can be seen as welcome central bank support for innovation in the area of sustainable finance.

[1] For more, see 10 Years of Green Bonds: Creating the Blueprint for Sustainability Across Capital Markets on https://www.worldbank.org/en/news/immersive-story/2019/03/18/10-years-of-green-bonds-creating-the-blueprint-for-sustainability-across-capital-markets


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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

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Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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