Growing comfort with the use-of-proceeds bond model is driving innovation, diversity and more granular outcomes for sustainability-oriented investors, says Stephen Liberatore of Nuveen.
Environmental Finance: Nuveen is something of a veteran of impact investing in the fixed income market and has won a handful of categories in Environmental Finance's IMPACT Awards 2023. How has the year shaped up?
Stephen Liberatore: It's been a good year, so far. We're seeing an ever-increasing opportunity set within the impact space, with greater depth and breadth of offerings. That is a function of outright investor demand, acceptance and understanding of the use-of-proceeds model, and a recognition from issuers that there is a very large, growing and sticky base of capital potentially available to them that they may not have access to otherwise.
The amount of issuance in the labelled market has increased this year. The key has been increasing diversification of impact outcomes, alongside improving granularity and transparency in reporting. That means we've been better able to align our investors' demands and values with securities we can invest their money in. As a long-term active manager, an increasing opportunity set provides us with greater potential for outperformance over time.
EF: You're particularly active investing in smaller issues, many of which involved you working with the issuer to help bring them to market. This is, presumably, a resource-intensive process. What are the benefits to Nuveen and your investors from doing this work?
SL: Our investment process is driven by the approach that an impact investment has to have a direct and measurable environmental and/or societal benefit. There are a lot of instances where we've participated in unique transactions, but what we're trying to do is create security structures that are replicable.
Take the Rhino bond from the World Bank, which is funding programmes to help increase the population of black rhinos in two South African game parks. It demonstrated strong alignment between all parties involved: the issuer, who wants to support growth in an emerging market; the success payor – the Global Environment Fund, whose mandate is to increase global biodiversity; the park operators, who benefit from the ecotourism; and the local communities that are provided increased employment and environmental opportunities. To ensure credibility, we brought in third parties to verify the data.
We're setting up structures that can be reproduced globally, especially as we talk more about biodiversity investing. It increases the opportunity set for us, and we believe that the more of these types of securities we see, the more opportunities we have, the better off our clients will be in pursuit of active returns and targeted impact outcomes. These are the types of investments our investors are looking to participate in. Deals like these allow us, as an active manager, to align their convictions with their portfolios with securities that have the potential to outperform over time.
EF: Your team also has an active engagement programme. What have your engagement priorities been, and what successes can you point to?
SL: In contrast to equity funds, who engage as shareholders, we tend to engage before we invest. For us to invest, the transaction has to fit our proprietary impact framework: each deal must meet strict criteria for us to participate, so the majority of the engagement work is on individual securities and transaction structuring. Many of the investments we make are the result of our engagement. In a lot of cases, we engage but ultimately don't participate, because the issuer can't or won't provide the reporting we require. That's an outcome as well. Our engagement on the Vietnam clean water/emissions-reduction bond in early 2023 is a great example of getting clear use of proceeds and transparent reporting in a first-of-its-kind transaction that meets our impact criteria.
We also spend a lot of time talking to other institutional investors to educate them about some of the deals we're involved with, such as orange bonds – social bonds with a gender lens. I'm thinking of the Women's Livelihood Bonds, where we've spent time speaking to other investors who have then come into that series.
EF: The awards judges were particularly complimentary about your impact reporting. What sets your reporting apart, and what are the challenges you face in producing it?
SL: It starts at the beginning, with the engagement process. We want to make sure that issuers understand our expectations in that we are looking for direct and measurable use of proceeds that are environmentally and/or societally aligned. We want to make sure that we get across to issuers the need for that relevant and sufficiently granular reporting that explains how the use of proceeds from that particular deal were deployed.
The challenge is that it's then a very manual process of making sure we obtain the data from issuers, analysing whether the metrics are collected as expected, and that the outcomes are aligned with how we understood the transaction. We then spend lots of time producing our own impact reporting, making sure it's clear, concise and credible. There's no other way to do it at this point. You just have to be willing to spend the time.
EF: You have been vocal in your concerns about sustainability-linked bonds (SLBs) and have avoided the asset class. But you have also suggested improvements to the SLB structure. What would it take for Nuveen to consider SLBs investible?
SL: One recommendation we have consistently made that we thought might have potential would be to structure a true use-of-proceeds green bond with additional KPI targets attached, essentially a 'green SLB'. Chilean paper company Inversiones CMPC issued this exact structure earlier this year, where proceeds were targeted to eligible project categories such as the circular economy, sustainable water and wastewater management and renewable energy, but also included sustainability performance targets tied to Scope 1 and 2 emissions. Given the direct and measurable use-of-proceeds, this security met the requirements of our proprietary Impact Framework and we were able to participate.
However, the issues with SLBs persist. Generally, KPIs are not aspirational and the penalties associated with not meeting the KPIs are not incentivising. The market has pretty much accepted a 25 basis point penalty, which hardly incentivises management to do something when 10-year US Treasuries yield 425 basis points. For us, the SLB structure is too easy to game and lacks the clarity of use-of-proceeds bonds.
EF: What does next year hold for Nuveen's Fixed Income ESG/impact investing team?
SL: I think we're going to continue to see pretty rapid growth in the industry overall: I wouldn't be surprised if we get back to $1 trillion in labelled bonds. We're going to see more specific and granular outcomes, based on greater investor comfort with the use-of-proceeds model – such as bonds tied to carbon credits and more transactions around biodiversity. It's going to be another really exciting year, especially if we see a lowering of interest rates globally, which will stimulate additional issuance.
Stephen Liberatore, CFA is a senior managing director and head of ESG/impact – fixed income at Nuveen in Charlotte, North Carolina.
For more information, see: https://www.nuveen.com/global/investment-capabilities/fixed-income/fixed-income-impact
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