More colour in the bond market
Yields remain low but a lot is going on below the surface
An article by Christian Kopf
Head of Fixed-Income Portfolio Management
In a nutshell:
At first glance, nothing appears to have changed for the European bond market in 2021. Central banks in the eurozone continue to buy paper, and low yields are the order of the day. But a lot is going on below the surface, and the bond market is growing more diverse and more colourful: greener, bluer and longer-dated. New types of bond and paper with ultra-long maturities are featuring more prominently. It is time to take stock and find out more about these ‘exotic’ instruments and about what investors need to bear in mind.
The market for sustainable investment has gained significant momentum since the Paris Climate Change Conference in 2015, with ESG criteria (environmental, social and corporate governance) at the centre of attention. Investors want to play a part in financing the shift to a sustainable economy through their investments. Since 2010, more than 900 euro-denominated sustainable bonds – such as green, social, sustainability, and sustainability-linked bonds – have been issued with a total volume of around €600 billion. These figures are set to rise sharply. More than a third (342) of these bonds were issued in 2020, despite the effects of the crisis. Green bonds, which have been an established instrument for some time, were joined in recent months by other types of sustainable bond: social bonds and sustainability-linked bonds.
Boom for green bonds and social bonds
The first green bond was issued by the European Investment Bank back in 2007. Yet the total volume of this market had only reached €52 billion by the end of 2015. Since then, the European Union (EU) has put forward an ambitious roadmap for the transition to a sustainable economy and insists that the entire financial sector must play its part. Companies and governments are under growing pressure to plough resources into environmental and social objectives.
In 2021, the volume of green bonds in circulation is likely to increase by around €75 billion.
Interest from investors has also continued to increase, as can be seen from the rapid growth of the market for green bonds. The market volume is now €508 billion, which is around ten times bigger than it was five years ago. For 2021, Union Investment predicts that the volume of green bonds in circulation will grow by a further €75 billion or so.
The market for green bonds is ten times bigger than it was in 2012
Green, blue, sustainable
Green bonds, which have been an established instrument for some time, were joined in recent months by other types of sustainable bond. How do they all differ?
Green bonds are exclusively related to individual projects with climate-related or environmental objectives.
Sustainability bonds and social bonds are also restricted to particular purposes. Sustainability bonds are used to finance a combination of environmental and social projects and are aligned with the blueprint set out by the United Nations with its 17 sustainable development goals (SDGs).
Social bonds are focused on social matters, for example the financing of social housing or an affordable water supply. If they have a link to water, social bonds are also referred to as blue bonds. The EU’s first social bond generated huge demand when it was issued in 2020. If all the loans and subsidies approved by the European Council that form part of the coronavirus support package are taken up, the EU will become a major player in the capital markets by 2026 with bonds totalling up to €850 billion.
Sustainability-linked bonds, which were introduced last year, are issued for companies’ general financing purposes but this should include helping the companies to become more sustainable. The amount of the coupon is dependent on the achievement of certain sustainability targets.
Faced with all these new types of bond, the challenge for investors is to ascertain whether projects or companies are being presented as greener or more sustainable than they actually are. However, the ICMA’s voluntary standards for these bonds have attracted a high level of buy-in and are having a significant effect in the market.
Europe is leading the way when it comes to the transparency of green and social bonds because important documents proving adherence to the standards are made available at the time of issue. This makes it easier to compare the different bonds. Such documents are rarely provided in Asia or the US. Nonetheless, investors still need to study the issuers and their bonds very carefully in order to rule out greenwashing.
Despite the rapid growth, this is still a niche area of investment. Last year, euro-denominated ESG bonds were issued in a volume of €220 billion. To put that into context: the total volume of euro-denominated bonds issued in 2020 was more than €3.5 trillion.
At global level, Germany still lags behind in terms of the number of ESG bonds issued (see the chart ‘Germany is among the biggest issuers of sustainable bonds’) but began to catch up in 2020. Last year, 144 ESG bonds from Germany were placed in the market, ahead of Japan (143), Korea (140), Sweden (127), France (87) and the US (83).
Low interest rates are supporting ultra-long paper
As well as the focus on how bond proceeds will be used, another discernible feature of the market at present is the trend for ultra-long-dated bonds. The ECB is likely to stick to its policy of negative interest rates. Governments and companies are therefore showing increased interest in obtaining finance over longer and longer periods. By doing so, they aim to make their financing more predictable and protect themselves against the risk of rising interest rates in the medium term. Maturities rarely seen in the past are now becoming increasingly prevalent in the market.
Buyers are playing ball. Extremely expansionary monetary policy means that investors who are reliant on returns are ever-more willing to buy very long-dated paper with yields that are just into positive territory. A few years ago, they would have paid them no attention. This demand is forcing more issuers to act if they want to secure such low interest rates for long periods.
The volume of government bonds issued with a term of more than 20 years is likely to hit a record high in Europe in 2021. On 19 January, France issued a 50-year bond with a yield of 0.59 per cent. Such long-dated paper is taboo for the German Finance Agency, which is the country’s debt manager. But the federal states have no such qualms, and North Rhine-Westphalia has previously issued 100-year bonds. Countries such as Austria and Mexico have also issued 100-year bonds. According to Bloomberg, 68 100-year bonds have been issued with a total volume of €40 billion since 2000. Last year alone, there were 19 such issues with a volume equivalent to €9.7 billion.
Investors have more choice but also face more complexity
The persistently low level of interest rates is good news for governments, banks and companies because they can repay their debts over ever-longer periods and barely have to pay any interest. This is forcing investors to take on much higher risks in order to receive any coupon payment at all. But for many of them, a yield that is just into positive territory is still better than a negative interest rate at the central bank.
Diversity is increasing markedly. A growing number of bonds that are unambiguously sustainable and have longer maturities are likely to be issued in future and will meet with stronger demand.
Overall, the diversity of the bond market is increasing markedly. This makes analysis more difficult. The only way to determine whether an issue meets the investor’s requirements from a climate change or ESG perspective is to conduct analysis at individual company level. Merely relying on established standards is not a good enough basis on which to make an investment decision.
As seen with traditional bonds, a growing number of sustainable bonds with long maturities are likely to be issued in future. Demand for instruments that are unambiguously sustainable is expected to increase. Companies and governments that do well here will be able to command more favourable funding conditions.
As at: 1 February 2021.