16 February 2022
The growing investor focus on the transformation to a net-zero economy is being increasingly reflected in the bond market, says Marcus Pratsch
Since the birth of the green bond segment in 2007, the sustainable bond market, with its many colours and facets, has already made a positive contribution to support financing the global sustainability agenda. Without a doubt, green bonds were a good start for funding environmentally sustainable activities.
However, the race to reach net zero emissions by 2050 requires all sectors to make their contribution. Hence, many issuers in those sectors have to completely rethink their business models.
Some of them will find decarbonisation easy. Others face major challenges and still have to figure out the how and the when.
That is perfectly fine. Rome wasn't built in a day. It is not possible to become net zero overnight. The journey of a thousand miles begins with the first step.
Moving in the right direction will involve a transition period. Hence, banks, whose role is increasingly changing from a traditional financial intermediary to a sustainable finance intermediary, need to become a reliable partner for transition candidates who express their credible transformation ambitions through the fixed income market, for example.
It is a win-win-situation, as transition bears huge opport- unities for bond investors identifying the "sustainable issuers of tomorrow".
Therefore, transition financing will become one of the key drivers of the sustainable bond market. But let's first take a look back at the past year.
In 2021 green bonds struck back
Without doubt, 2021 was another exciting year for the sustainable bond market, which just missed the $1 trillion mark.
After a conciliatory end to a Covid-19 plagued 2020, green bonds set new records in 2021. With a new issuance volume of almost $75 billion, September was the most successful month to date since the birth of the green bond segment. Furthermore, a new giant has emerged in the market, as the European Union will raise up to 30% of the NextGenerationEU funds through the issuance of NextGenerationEU Green Bonds. With the maiden issue of €12 billion in October, the world's largest green bond to date saw the light of day.
Overall, the new issuance volume in the green bond segment amounted to $500 billion, and hence more than 85% above the previous year's level.
In addition, social bonds and sustainability bonds continued to enjoy tailwinds in 2021.While the new issuance volume of the former increased by slightly more than 30% to $185 billion, the latter showed the highest growth rate in the entire sustainable bond market, up more than 140% to $165 billion.
This underlines the trend of "green goes rainbow", reflecting the ongoing diversification in the sustainable bond market.
The segment of 'transition and target-linked financing', which includes transition bonds as well as target-linked bonds, also showed impressive growth of more than 120% to around $100 billion.
In our opinion, this segment will receive special attention in the future, as we can only successfully implement the global sustainability agenda if we "get everyone on board", i.e. also issuers from critical sectors with business activities whose journey on the transformation path will still be a longer one.
In 2022, the trillion dollar mark in the sustainable bond market will be exceeded
We expect all segments of the sustainable bond market to grow in 2022.
We forecast the new issuance volume in the green bond segment to increase by 50% to $750 billion. The segment is thus increasingly moving towards the $1 trillion mark, which we estimate will be exceeded in the course of 2023.
"Instead of divesting, more and more asset managers are entering into an active dialogue with critical industries on the subject of transformation"
In the social bond segment and in the sustainability bond segment, we forecast a new issuance volume of $200 billion each, corresponding to growth of 8% and 21%, respectively.
Due to the increasing importance of transition financing, the segment of 'transition and target-linked financing', which includes transition bonds and target-linked bonds, is expected to grow the most. Here we forecast a 60% increase in new issuance volume to $160 billion.
Overall, the sustainable bond market will therefore exceed the $1 trillion mark in the course of 2022, reaching a new issuance volume of around $1.3 trillion.
Use-of-proceeds transition bonds – loved and hated at the same time
The global fixed income market has a key role to play in financing the transformation of the real economy. With an estimated volume of more than $100 trillion, it holds enormous potential to support the transition to a sustainable future.
Yet transition is one of the most controversial topics when it comes to sustainable financing in the bond market.
This is illustrated by the example of so-called transition bonds. Transition bonds are a relatively new fixed income instrument that joins the ranks of use-of-proceeds sustainable bonds. They are designed to enable issuers from less sustainable sectors to finance a gradual shift to a more sustainable business model.
These include carbon-intensive industries such as oil and gas, iron and steel, chemicals, aviation and shipping. Proceeds from the issuance of transition bonds could be used, for example, to finance transformation technologies that enable the transition to a more sustainable business model.
Opponents of transition bonds question the authenticity of such instruments. They see them as softening the market for sustainable bonds. The accusation of "greenwashing" is often raised, i.e. an attempt by the issuer to gain a "green image" through the transaction without having systematically anchored corresponding strategic measures in the operational business.
Proponents of transition bonds, on the other hand, argue that the transformation of our economy cannot succeed through "black and white" thinking such as sector-specific exclusions with the intention of completely restricting external capital flows.
Clearly labelling a bond as a "transition bond" creates transparency for investors and clearly differentiates it from green bonds.
We must leave no one behind
The global real economy is currently undergoing a fundamental transformation process in light of changing demands due to environmental and social challenges as well as digitalisation and globalisation. Massive investments are needed to make business models, production methods and processes fit for the future and thus take advantage of the opportunities offered by sustainable development.
The need for transition financing with regard to a successful implementation of the global sustainability agenda is therefore undisputed. In doing so, it is necessary to put an end to the classic "black and white" thinking.
We cannot achieve a decarbonised and more sustainable world by focusing exclusively on economic activities, business models and sectors that are already "dark green". We can have a much greater positive impact on the global sustainability agenda by helping to make "brown" economic activities, business models, and industries "light brown" or "light green," rather than painting already "dark green" activities, models, and sectors one shade greener.
Against this backdrop, no one who can demonstrate a feasible and transparent transformation path should be excluded from sustainable financing.
The financial sector, in its new role as a sustainable finance intermediary, has a key role to play in supporting this transformation process. It should act as a reliable financing partner to also support critical actors and industries in a sustainable and credible transformation.
In terms of sustainable structural change, it should help to preserve, strengthen and expand strategic expertise and value creation. It should also help to secure the competitive position of many companies in the long term. Finally yet importantly, the financial sector must accompany the "future champions" on their way to sustainable market leadership.
Target-linked bonds: innovative instrument for credible transition financing
Numerous innovations have contributed to the success story of the sustainable bond market in recent years. For example, target-linked structures have been extremely popular for some time. In 2021, they already accounted for around 10% of the new issuance volume in the global sustainable bond market.
Many investors see them as a suitable instrument for transition financing. Unlike the use-of-proceeds transition bonds mentioned above, they focus on the transformation of the issuer as a whole.
Target-linked bonds are forward-looking and performance- oriented financial instruments in which issuers explicitly commit (also in the bond documentation) to future improvements in sustainability criteria within a predefined timeframe. Sustainability development is measured using predefined key performance indicators (KPIs) and evaluated against sustainability performance targets (SPTs).
The financing costs of target-linked bonds are linked to the (non-)achievement of these sustainability targets. If the issuer fails to meet the targets, financing becomes more expensive.
As the use of proceeds of target-linked bonds are not earmarked and can therefore also be used for general corporate financing, they are also suitable for less asset-intensive issuers who do not have the necessary volume for a use-of-proceeds transition bond.
For credible transition financing using target-linked bonds, it is important to choose KPIs that are relevant, measurable and comparable, central and essential to the issuer's transformation process. They should also have a high strategic importance for the issuer's future operations.
In addition, the SPTs should be in line with the issuer's transformation strategy and be ambitious, i.e., go beyond a "business-as-usual scenario".
"Transform instead of divest": a new credo of many asset managers
Investors are playing an increasingly important role in financing the transformation of the real economy. They are gradually becoming companions to companies that are transforming credibly. There is therefore a new credo among many asset managers: "Transform instead of divest".
In the past, a large number of sustainable investors focused on strategies such as exclusions or best-in-class approaches. Those companies that did not fit into the grid were sold.
Today, investors are increasingly interested in the transformation potential of the real economy. Identifying the "sustainable companies of tomorrow" is becoming more and more important.
In this context, it is worth noting that transformation is not limited exclusively to environmental aspects, but also includes an economic, a social and a governance dimension.
Instead of divesting, more and more asset managers are entering into an active dialogue with critical industries on the subject of transformation.
In the spirit of active ownership, for example, they are increasingly using their voting rights and influence at companies' annual general meetings to make them more sustainable. As owners, they thus actively exert influence on the future orientation of the real economy.
The option to sell always remains – but only as ultimo ratio if, for example, a company abandons the promised, credible transformation path.
An increasing number of fixed income investors is also discovering – in their role as key stakeholders – the possibility of engagement with promising transformation candidates. While they do not have voting rights, they can enter into an active dialogue with the management of the companies being transformed, either on their own or through joint collaboration with other investors.
Through this active engagement, they can encourage companies to be more transparent in their disclosure of ESG factors, better manage material sustainability risks, and follow a proper and credible transformation path.
Marcus Pratsch is head of sustainable bonds and finance at DZ BANK AG.