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Bonds have their own ESG troubles

The ESG boom has reached the bond market, with mixed consequences for investors
July 13, 2021

The craze for environmental, social and governance (ESG) assets is too big for fixed-income investors to ignore. That’s one view from M&G’s bond team, which recently highlighted an explosion in the issuance of ESG-themed corporate debt. As fixed-income investment director Mario Eisenegger notes, companies issued new ESG bonds worth $350bn in the first half of 2021. That’s already ahead of the total amount for 2020, itself a bumper year for issuance of ESG corporate debt.

Bond investors will increasingly have to account for ESG considerations, even if such issues aren’t their first priority. This is great news if you do care about it: your concerns are being catered to more widely outside the stock market. But as with stocks, this boom creates a whole set of fresh complications.

First of all, there are many different forms of ESG bonds to understand. While investors are likely to differ on both the use and interpretation of certain terms, M&G's Eisenegger has previously described the universe as follows. First, green bonds, the most established form of ESG debt, will be used to finance environmentally friendly projects. There are also social bonds, sustainability bonds (which can combine green and social projects) and 'blue' bonds, which focus on ocean conservation. Transition bonds are used to help businesses shift to a greener business model, while so-called sustainability-linked bonds tend to come with an income payment linked to the issuer hitting certain sustainability targets. A failure to hit said targets would tend to result in the payout to investors rising.

All this means investors need to ask what type of ESG matters to them – and what stands out as an investment. Then, of course, we have the classic conundrum: which debt issuers are walking the walk and what are the risks?

To start with the risks, not all ESG bonds are being issued by those companies that seem most likely to comfortably make their income payments. M&G notes that ESG issuance was worth a fifth of the total European high-yield supply in the first half of 2021, meaning there is a good tranche of riskier (but higher-yielding) debt with an ESG label. This might fit in with the IC's Alex Hamer’s observation from December that ESG bonds are not just linked to wind farms – some commodities names have been raising money to help clean up their act, for example. This links to a lively debate among equity investors on whether they should only buy stocks that score well on ESG metrics, or instead invest with companies in 'bad' industries and encourage them to improve practices (via options including transition bonds).

Finally, as with stocks it’s worth asking which ESG bonds are the real deal. Eisenegger points to a US meat producer that came to market with a sustainability-linked bond last month despite having recently pleaded guilty to US foreign bribery charges. “It is debatable whether a company with severe governance issues should tap the market with sustainability-linked bonds, and investors need to be aware of such potential conflicts," he adds.