Overview
There’s an exceptionally large elephant in the sustainable investing room. A 25-trillion-dollar elephant. That was the size of global fixed income issuance in 2023 compared to equity issuance of just over USD $420 billion.[1] If fixed income markets are so much bigger than equity markets, then why do equities continue to dominate the discussion around transition finance?
One reason is that the bonds, as ever, seem more complicated than the equity market. Investing in the latter generally consists of buying sustainable stocks. Any complexity comes from deciding which ones are sustainable.
Much of the sustainable debt market is structured differently. ‘Green bonds’ evolved out of a 2007 World Bank debt issuance that channelled lenders’ money into environmental projects. So began the labelled sustainable debt market, in which investors buy a bond not necessarily because of the issuer’s green credentials, but because of the specific projects their money is being used to finance.
Green bonds now represent the first port of call for fixed income investors looking to lean in to the transition. Despite some well-noted concerns hovering around the construction of these markets (more on those later), they have done an admirable job of tapping the transition potential of fixed income. The branding that comes with green, blue, social, or other similarly labelled bonds can provide a useful signal for strategies that need certification of ESG-focused securities.
But they’re not the only option available to investors. Look beyond the colourful monikers, and you can find plenty of sustainable, non-labelled, debt. Take for example the bonds issued by WoDS Transmission, an organisation that sends roughly 389MW of clean energy from an offshore windfarm in the Irish Sea to the UK grid. WoDS provides a significant part of the infrastructure that underlies the UK’s effort to achieve net zero emissions by 2050. It would be odd for investors to overlook its bonds just because they’re not labelled ‘green’.
Beat the greenium
It might not make financial sense either. The distinction between labelled and non-labelled debt is important because it offers one way round the green premium. This ‘greenium’ refers to the additional yield investors surrender owing to the increased demand for sustainable debt. It’s long been an issue for the labelled market - not so much for the non-labelled one. There are of course legitimate reasons why investors may overlook the greenium - for instance, to meet certain green- label quotas for their portfolios - but it should also encourage investors to consider which parts of the market serve them best.
That dilemma can be seen most visibly in companies issuing both types of debt. One business that supports people with disabilities, for example, issues both non-labelled and labelled ‘social’ bonds. A labelled bond like this would usually allow companies to highlight the social projects underlying an issuance, which stand apart from its ordinary debt. But the distinction in this case would appear moot given the company’s usual business operations already serve a social purpose. The primary difference between the two lies in the six basis points of extra yield available on the non- labelled bonds over the social alternative.
There is another reason investors may wish to look beyond labels. Any company can, in theory, issue a green bond. The advantage for sustainably-minded investors is that they obtain a green stamp for their strategy as well as confidence that their money is (usually) ringfenced in support of an environmental purpose. The disadvantage is they have no influence over how the company uses its other cash piles.
By contrast, buying non-labelled debt requires the investor to take a view of the issuer and not just the particular bond on offer. That’s useful when it comes to buying the bonds of a company like Broadcom. Broadcom is the world’s seventh largest semiconductor company, meaning it has a material role in fitting the world’s existing infrastructure with cleaner technology.
Broadcom does not issue labelled green bonds- that is, bonds funding a specific green use of proceeds. But that does not mean their bonds aren’t green. Proceeds raised from the company’s bond issuances support its ongoing business activities, which in turn support the energy transition (even if there are wider questions around the scope 3 emissions of the technology sector).
Moreover, a lack of investor confidence around how exactly companies plan on using lenders’ capital has been one factor stunting the growth of labelled debt markets. Definitions over what constitutes ‘green’ have improved, yet it was only two years ago that one airport authority raised $1 billion through the issuance of a green bond to help fund the development of a third runway. We’re confident though that as these frameworks develop further for labelled bonds, investor interest, and market strength will only increase.
Buying non-labelled securities requires the investor to form a reasoned opinion of the companies’ sustainability credentials in the first order. The lender does not need to separate their view of the issuer’s regular business activity from that of a particular bond. It simplifies the job of screening and plays to the strengths of fixed income investors’ active credit research and engagement.
Tackling the transition
At the same time, the buying of non-labelled bonds also allows investors to take on the trickier sides of financing the transition. Hard-to-abate sectors, including energy or mining companies, tend not to issue green bonds even when they’re making serious moves to transition, because they know investors are prone to doubt the intentions or the credentials of the company. ‘Transition bonds’, issued by brown companies to fund their progress, were designed to fill this gap but have similarly struggled to gain momentum.
Yet these companies too require funding to support their transformation. The job of ensuring they’re up to the task falls upon the investors themselves, through active research of the company’s credentials followed by frequent engagement to track progress.
That’s hard work, but funding the green energy transition never promised to be easy. It’s clear that doing so requires active mobilisation of fixed income markets, which are too large for sustainable investors to overlook. Buying labelled bonds is one way - good old-fashioned credit research is another.
