Cutting Through Labels’ Noise in the Sustainable Bond Market: The Merits of a Research-Driven Framework

An Evolving Sustainable Bond Landscape

While 2022 seemed to mark a slowdown in the global supply of labeled Sustainable Bonds,¹ YTD issuance has already exceeded last year’s figures for the same period, with over US$600 billion as of June 2023. In Q1 and Q2 2023, the labeled bond market saw its strongest two quarters since Q2 2021, primarily thanks to Green Bond issuance, which continues to solidify its role in the wider labeled bond market, with a focus on the environmental side dominating new issuances. 2023 has been penned to be a record year for Green Bonds despite increasing regulatory scrutiny²—in fact, our Calvert ESG analysts have identified greater standardization among green financing frameworks (i.e., the documents published by Green Bond issuers, outlining their sustainability strategy, eligible Green projects, and governance around issuance of these instruments), especially following a pickup in guidance from the European Union (EU) on their Taxonomy, and on the provisional EU Green Bond Standard.

As of June 30, 2023 the Sustainable Bond market has grown to a total of US$3.6 trillion in outstanding value. While this is still small when compared to the estimated size of the global bond market (~US$130 trillion),³ it is a meaningful universe for sustainable investors to operate in. To put it into perspective, when breaking down the global bond market into more specific investable universes, the Euro Corporate Bond universe is about US$2.7 trillion in size, whilst the U.S. High Yield Bond universe is about US$1.2 trillion.⁴

FAVORABLE CONDITIONS FOR A STEADY SUPPLY OF SUSTAINABLE BONDS AND DECREASING TRADE-OFFS WITH VANILLA BONDS…

We view the key drivers of demand for labeled sustainable issuances, particularly green and other use-of-proceeds structures, to be twofold:

1. PRODUCT-LEVEL REGULATORY EVOLUTION

The EU Sustainable Finance Disclosure Regulation (SFDR) has contributed to higher demand for labeled use-of-proceeds bonds, as outlined in our 2023 ESG Outlook paper. In Q2 2023, Article 8 and 9 assets surpassed the EUR 5 trillion mark,⁵ with some Article 8-classified funds committing to making a minimum allocation to “Sustainable Investments”,⁶ and Article 9 funds intended to invest exclusively in Sustainable Investments. In our view, the earmarking of financing dedicated to strictly sustainable projects makes use-of-proceeds sustainable bonds ideal candidates for being considered Sustainable Investments, as long as their underlying frameworks are robust and aligned with market best practice—something that we assess in depth through our Sustainable Bond Evaluation Framework, described below. As a result, we believe the need to fulfill Sustainable Investment allocations across the over 50% of the European-domiciled universe of Article 8 and 9 funds that have set such commitments continues to drive investor demand for these sustainable instruments.

2. LIMITED TRADE-OFF WITH VANILLA COUNTERPARTS

While we identified a potential risk in our 2023 ESG Outlook paper of the “greenium” (i.e., the excess new-issue premium associated with a bond’s label) being driven up due to increased demand for Sustainable Bonds, there seems to be growing research evidence that greeniums are, over time, starting to dissipate. We note that in general, the presence and magnitude of a greenium depends on the nature of the issuer (in terms of sector, jurisdiction, credit and ESG ratings) and the frequency of labeled bond issuance. Sectors with a consistent and ample supply of Sustainable Bonds and recurrent issuance, in particular utilities, and sovereign, supranationals and agencies (SSA), which constituted approximately 45% of total sustainable bond issuance in H1 2023,⁷ tend to show negligible/diminishing greeniums.

Even in the presence of some visible basis points of greenium, we do not think that this will have a meaningful impact on the performance of a portfolio invested in such instruments, for a number of reasons. First, the greenium, while being a constant in the market, is relatively small in terms of carry. This is especially the case as risk-free rates are significantly higher today than they have been over the past decade. As such, the negative contribution to carry from the greenium has become increasingly marginal. In addition, while the yield may be lower, green bonds tend to be very closely held due to their relative scarcity. As such, the volatility of the bond price tends to be lower than the volatility of unlabelled equivalents. We find that this increases the attractiveness of the security. Finally, there are some parts of the market where the greenium is less apparent, for instance, the higher spread parts of the market, such as High Yield and Securitized bonds, where greenium has been less constant and, in fact, the green bond sometimes trades wider than the non-green versions.

Liquidity has also historically been a concern for green bond investors. We believe this has continued to improve as a result of increasing supply and greater alignment to market standards—studies have also shown that green bonds with strong “greenness ratings” from Second Party Opinion (SPO) providers have higher liquidity.⁸

…WITH A SMALLER PORTION OF THE MARKET STILL WORKING TO FIND ITS FOOTING

While the market for Green and other Sustainable use-of-proceeds bonds is starting to mature, other instruments still have a long way to go. This is the case for Sustainable Bonds, where the issuer commits to the attainment of one or more specific sustainability targets (or, the payment of a penalty), but proceeds are directed towards general corporate purposes. While we see that efforts in the market have been made to improve transparency for these instruments,⁹ and we see this structure as a potential lever to grow sovereign sustainable bond issuance, especially from emerging markets, we believe the risk of greenwashing, particularly for corporates, is higher than for use-of-proceeds bonds, especially in cases where the sustainability performance target(s) lack ambition or robustness (such as targets covering a non-material proportion of carbon emissions, or call dates predating sustainability targets’ trigger dates). Against the backdrop of SFDR then, the ability of these sustainability-linked structures to meet sustainable investment allocation requirements is reduced—such as for Sustainable Bonds from high emitters, which may not pass the emissions indicators in the regulation’s Do No Significant Harm test. Increasing regulatory and investor scrutiny on these instruments has been reflected in a declining share of issuance of SLBs versus use-of-proceeds bonds.¹⁰

To avoid these concerns, across both Sustainable Bonds and use-of-proceeds bonds, we believe it is imperative to fully analyze the robustness of sustainable financing frameworks, in order to leverage the full potential of these investment to result in positive impact and help achieve real-world outcomes.

Cutting Through the Noise of Labels With Proprietary Sustainable Bond Evaluations and Research

The rapid growth and development of the Sustainable Bond market, and the large quantity of unique information available to investors in these instruments, makes it a priority for investors to conduct an in-depth assessment of each transaction. This process helps ensure these securities live by the issuer’s claims, abide by market standards, and, if intended to be purchased for a Sustainable Bond portfolio, align with the product’s objectives.

At Calvert, we believe that undertaking a rigorous process to evaluate the sustainability characteristics of these investments not only maintains the quality of bonds held in our portfolios but shows our commitment to supporting positive environmental and social outcomes alongside financial returns.

SPOs and other verifications by external providers play an important role in providing Sustainable Bond investors with a more standardized set of information while increasing the transparency surrounding Green Bond frameworks and transactions. However, we believe that the true value of this granular information lies in its interaction with our proprietary Calvert ESG research platform. The investment team’s own view on the materiality of a labeled bond transaction in the context of the issuer’s sustainability strategy and its performance on related topics, allows for a nuanced assessment of the credibility of these investments, supplementing the underlying fundamental credit analysis.

Calvert has developed a comprehensive Sustainable Bond Evaluation Framework (Display 2 - see below) to drive a structured, systematic assessment of our investments in Sustainable Bonds, both at issuance and throughout the life of the bond. Our Sustainable Bond Evaluation Framework is aimed at:

• Determining whether a labeled transaction is aligned with, and can materially contribute to, the issuer’s overall sustainability objectives;

• Assessing the extent to which the use of proceeds or targets associated with the bond can help catalyze additional financing towards innovative, low-carbon or other environmental solutions, and identify any risks of lock-in of high-carbon, polluting technologies; and

• Verifying the transaction’s alignment with applicable market standards, including the International Capital Market Association’s (ICMA) Green and Social Bond Principles and additional guidance, international taxonomies such as the one developed by the EU, and the Climate Bonds Standard, and benchmarking it against leading practices within the applicable peer group and jurisdiction.

These evaluations enhance the information available to portfolio managers and credit research analysts, furthering their understanding of how effectively issuers are managing material ESG issues and leveraging opportunities stemming from the low-carbon transition, and they are an integral component of the investment decision process for these instruments. Calvert’s Green Bond strategies only invest in labelled bonds that have been assessed positively through this framework.

We rely on our deep experience in the market to uphold standards for the additionality of selected projects or targets to be financed. In particular, the Sustainable Bond market offers a unique opportunity for fixed income investors to engage with issuers, at a time when issuers and their management are particularly sensitive to investor feedback on sustainability. Applying a robust research process provides us with an effective platform to push for improvements in the structure of these instruments as well as surrounding disclosure. We do this through bilateral engagement with issuers during their preparation of new transactions, especially for inaugural Sustainable Bond issuances, but also by communicating with structuring advisors and contributing to multistakeholder platforms.

With over 10 years of experience in managing Calvert Green Bond strategies, we believe we have a duty to contribute our viewpoints and encourage issuers and underwriters to strive to implement best practices to achieve meaningful positive sustainability outcomes through the issuance of robust sustainable bonds. As such, Calvert actively engages with Green Bond market players, and participates in industry initiatives, to promote robust sustainable financing frameworks that help effectively catalyze capital towards environmentally and socially impactful projects, transparent disclosures, and reporting.

¹ In this document, we refer to “Sustainable Bonds” as including Green, Social, Sustainability, Sustainability-Linked Bonds, and other analogous labels identifying bonds with associated environmental or social characteristics.
² Linklaters, Global green bond issuance reaches record high of $351bn in first six months of 2023 amid evolving regulatory landscape (2023).
³ International Capital Market Association (ICMA).
⁴ Source: Bloomberg Euro Agg Corporate Bond Index, and ICE BofA US High Yield Index, respectively, as of September 2023.
⁵ Morningstar, SFDR Article 8 and Article 9 Funds: Q2 2023 in Review (2023).
⁶ The EU SFDR refers to “Sustainable Investments” as those that make a positive contribution towards environmental or social characteristics, whilst doing no significant harm to other sustainability factors, and abiding by minimum social safeguards and good governance. The regulation does not prescribe specific eligibility thresholds for Sustainable Investments.
⁷ Source: Environmental Finance Bond Database, as of 30 June 2023.
⁸ Dorfleitner, Eckberg & Utz, Greenness Ratings and Green Bond Liquidity (2023).
⁹ Morgan Stanley Investment Management, Key Fixed Income Considerations for 2023 (2023).
¹⁰ Morgan Stanley Research, What’s Going on With Sustainability-Linked Bonds? (2023).