We ask Dany da Fonseca, CFA, Senior Portfolio Manager, why he sees rising sustainability in euro Investment Grade bonds
‘Sustainable Euro IG Corporate Credit’ is a mouthful. Can you break that down a bit for us?
Dany: Sure. We are essentially discussing investment-grade corporate bonds which are denominated in euros. Our specific interest is on the portion of the market which we consider sustainable issues and issuers, based on our 25 years of experience and the analysis of our independent in-house Environmental, Social, and Governance (ESG) team.
So why Euro? and why particularly now?
One might say that the European Union is the leading region in transparency of extra-financial and ESG factors. Regulation and financial markets are changing rapidly in the EU as the Commission pursues its European Green Deal goals of being the first climate-neutral continent. These new transparency regulations apply to both companies and investment managers, making it easier for asset owners and investors to ‘look through’ their portfolio components to see the aggregated sustainability data of the issuers in their investments.
More specifically to the fixed income markets, banks and insurance companies are a huge 35% of the it.[1] Globally, the ECB has been one of the most vocal banking regulators in pushing for transparency of climate risk in bank balance sheets. EU regulations require banks to assess whether they are, or will be, exposed to material climate risks, and to reflect these risks in their capital reserves, with the creation, for example, of the new Green Asset Ratio. This year, the ECB announced its first fines on several banks for their “protracted failure to address the impact of climate change.”[2] Could a ‘climate capital buffer’ be far behind?
How do ‘Green Bonds’ fit in today’s environment?
Green Bonds are probably the most well-known and easily-identifiable of the sustainable issues. Green, social, and sustainability bonds (GSS) are a €3 trillion category, or roughly 16% of the overall Euro IG universe.[3] Supported by voluntary guidelines, a new EU-sponsored set of standards will allow those issuers who both adopt the standards and have their reporting confirmed by external, supervised external reviewers will be able to describe their bond as a European Green Bond, or EuGB. This is a substantial step forward, encouraging for both issuers and investors. As this segment grows in importance, we hope to expand our target ownership of GSS bonds from 10% to 20% in our sustainable portfolio.
The issuance of GSS bonds signals a commitment by the issuer to transparency, accountability, and stakeholder engagement, which strengthens relationships with credit investors. Meanwhile, new types of bonds with sustainable features have also emerge, such as sustainability-linked bonds (SLB). Instead of individual bonds issued to finance a specific environmental and/or social projects, these represent a commitment at the company level. This means the company pledges to meet ESG targets across its entire operations, not just for individual projects. The issuer choses one or more relevant Sustainability Performance Targets (SPT) and a time horizon. If the issuer fails to achieve the target, investors are compensated, usually through a step up in the coupon rate until maturity of the bond.
We believe that Sustainability-Linked Bonds (SLBs) will inherently encourage markets to further incorporate ESG targets into pricing, Though the market is not fully efficient in reflecting the opportunities of some of these bonds. In our white paper, we discuss one of these inefficiencies.
Why do you think these new types of instruments are enhancing sustainability for Euro IG bonds?
As portfolio managers we are happy about these innovations, not just for the expansion of the GSS category, but because these new bond types are increasing interest in and demand for sustainability across the entire Euro IG market.
We also believe they contribute to the virtuous circle of transparency. The more issuers provide information for these particular types of bonds, the better they can themselves assess their own impact and the greater transparency investors have regarding all issues and issuers across the fixed income markets.
Why are you confident that sustainable bonds will perform as well as the market overall?
We think investors should consider two elements. One is whether the universe of sustainable bonds can perform as well as the broader market. The second is how the asset manager selects particular issues for portfolios.
Do investors pay a premium / accept a lower return for ESG in fixed income? On the one hand, we have the evidence that in some parts of the ESG markets such as ‘Green Bonds’, sustainable bonds have been generally discounted with a lower yield that the rest of the market -- even though we have moved past the peak of this trend. On the other hand, in building our ESG portfolios, we found that if we include only issuers and issues from our sustainable universe, as determined by our ESG and our fundamental analysts, there are almost no differences in spread. Sustainability is necessary, but not sufficient. Every bond is reviewed. After determining the fundamental soundness of an issuer, valuation matters. We must not overpay for ESG features.
It is our Conviction that both financial and sustainability performance will soon be at the forefront of Euro IG portfolios.
[1] iBoxx EUR Corporates (Total Return), frequently used to define European IG Corporate Credit. As of June 2024. The 35% figure applies to Banks and Insurance companies, excluding real estate.
[2] FN 8 from white paper
[3] Candriam estimates, and Bloomberg.