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Asset class / Fixed income

Pension funds set to fuel explosion in ESG bonds despite reservations

Sustainable bond issuance rocketed in the first quarter. Despite scepticism over their true purpose and impact, there is little evidence to suggest that demand will abate soon.

ESG bonds
Hiding behind the green branding? Investors struggle to determine the genuine impact of sustainable bonds. (Photo by Yuriy Zhuravov)
  • The global sustainable bond market has tripled in size to $231bn year-on-year, to account for 9.4% of total debt issuance, according to Moody’s.
  • Pension funds look set to drive further rapid growth in both demand for and supply of such assets.
  • Yet there remain major challenges around assessing the potential impact of ESG-focused debt – although these are expected to ease over time.

The groundswell of interest in responsible investing may have started with listed stocks, but it has well and truly spread to the public debt markets.

Global issuance of green, social and sustainability bonds – or sustainable bonds, collectively – hit a record $231bn in the first quarter of 2021, more than triple the figure in the same quarter last year, according to Moody’s Investors Service (see graph below). That already represents 9.4% of global debt issuance for the period and puts sustainable bond issuance on course to surpass the rating agency’s forecast of $650bn for this year.

Startling figures indeed for a relatively nascent segment, but merely reflective of the vast appetite for the environmental, social and governance (ESG) investment theme.

There are a number of reasons to think Moody’s prediction might even be conservative. To name a few: the huge untapped well of investor demand, the sheer size and level of influence of the fixed income markets, and the fact that pension funds look set to add to the supply of sustainable bonds as well as drive appetite for them.

On top of all that, the resources and expertise needed to assess sustainable debt are only going to grow, as are the transparency and data around these assets and their ultimate impact. And they will need to because they are yet not sufficient.

Consider the fact that many pension plans – an industry with $50trn-plus in assets, according to OECD data – have probably not even directly purchased their first sustainable bond.

That’s the case for the £6.5bn ($9.1bn) retirement fund of the UK’s Nationwide Building Society, one of the country’s larger corporate schemes.

Relying on third parties

“We haven’t bought any sustainable bonds because we weren’t really in a position to do in-depth analysis,” says Mark Hedges, who was chief investment officer at Nationwide Pension Fund for 41 years until he stepped down this month. He concedes that the scheme might have exposure via its external fund managers.

The Nationwide fund has a six-strong investment team, who report to the trustees and meet and monitor the asset managers, says Hedges, who is now a professional trustee himself. “There’s a limited amount of scope for many funds to do a lot of detailed analysis of investments.

Mark Hedges, trustee and former CIO of Nationwide Pension Fund: It’s hard to assess whether green bonds are having a real sustainable impact. (Photo courtesy of Mark Hedges)

“Unless they’re really big funds, pension funds have limited resources and are driven to a large degree by recommendations from their consultants,” he adds. “The whole ESG agenda is getting more and more traction. But unless you’re with a bigger fund it becomes quite hard to do the detailed work and understand a lot of this.”

The challenge for a trustee is always whether the fund is giving up any return on a risk-adjusted basis, says Hedges. “So, is the overall return on a risk-adjusted basis no worse, or can it be improved, from sustainable bonds?”

You’ve seen a lot of banks issuing, say, ‘green’ mortgage-backed bonds, when they were in fact already doing that type of lending. Mark Hedges, former chief investment officer at Nationwide Pension Fund

Another question is whether the debt is having a real, sustainable impact or is simply an issuer’s move to try to get a lower cost of finance, Hedges adds.

“You’ve seen a lot of banks issuing, say, ‘green’ mortgage-backed bonds, when they were in fact already doing that type of lending. There was nothing new there. The bank was really just finding a cheaper source of funds.”

Falling short of sustainability

Borrowers can typically pay slightly lower rates of interest on the debt they issue if its proceeds are designed to have, for instance, a positive environmental impact.

Yet it seems most are not fulfilling the necessary criteria. Only a “disappointing” 34% of the 285 so-called impact bonds that UK-based Insight Investment has rated since 2017 fully met all its sustainability requirements, the £753bn fund house said in its 2021 responsible investment report published last month.

So while Nationwide Pension Fund has understandably not allocated to sustainable bonds, it has felt more comfortable on the private credit side in this space.

This year it invested into a private credit fund that commits to paying its borrowers a better price for their debt if they hit certain ESG-related targets. “So [the corporate issuers] could make a saving by demonstrating a practical improvement in their business,” says Hedges.

It was the first time Hedges had seen such as strategy offered by a private credit manager, but he declined to name the firm in question.

On the equity side, Nationwide Pension Fund also decided this year to switch its roughly £1bn listed stock allocation to track an ESG benchmark: Legal & General Investment Management’s Future World index. The portfolio is passively managed and currently benchmarked to MSCI’s All-Country World and Emerging Markets indices.

“What we’re starting to see is a shift towards more sustainable, ESG-focused activity,” Hedges says. “So it’s inevitable that credit portfolios within pension funds will, over time, see a shift in the same way that they’re seeing a shift in equity holdings in this direction.”

The requirement for UK pensions to report based on the Task Force for Climate-related Financial Disclosures (TCFD) requirements is driving this trend, he notes. “But it’s actually doing real, tangible things that are going to improve the environment and address social and governance issues.”

Getting in on the green act

While pension fund appetite for ESG debt is set to multiply, the same institutional segment may also help increase the supply of sustainable bonds.

Canada’s Ontario Municipal Employees Retirement System (Omers), a big investor in infrastructure and other real assets, is considering a framework for potentially issuing its own green bonds.

We are particularly interested in green bonds as an issuer. Katharine Preston, Ontario Municipal Employees Retirement System

“We are particularly interested in green bonds as an issuer,” says Katharine Preston, Toronto-based vice president of sustainable investing at Omers, the C$105bn ($87.4bn) fund. “Many of our portfolio companies have issued green bonds, which provide attractive financing rates for qualifying projects.”

Ultimately, though, sustainable bonds remain difficult for even the largest, most well-resourced investors to analyse or get appropriate data on. It’s hardly surprising that smaller institutions struggle to assess the impact of sustainable bonds, says Josh Kendall, head of responsible investment at Insight.

Josh Kendall, Insight Investment: the European Investment Bank sets the standard for sustainable bond disclosures. (Photo courtesy of Insight Investment)

“There is no guidance for investors on how to think about this issue,” he tells Capital Monitor. “The whole responsible or sustainable landscape is entirely subjective.”

And on the corporate side, there is so much potentially relevant information that companies struggle to capture the information and make it accessible to investors, he adds.

“The new EU green bond standards and the EU taxonomy should introduce more market standardisation and give access to more complete information that will be relevant to investors,” Insight says in its report.

However, it adds: “Until more formal frameworks are enforced, it will be vital for investors to exercise appropriate due diligence to avoid falling victim to the rising risk of impact washing.”

In the meantime, issuers should be looking to the European Investment Bank (EIB) as the gold standard for disclosure, says Kendall.

“What you get from most other companies that issue green bonds is aggregate-level,” he adds. “You would see only one figure for each lending project, whereas the EIB has dozens of figures for each one.”

It is likely to be quite some time before the market in general reaches that level of transparency – but it is an example of what is possible, and a standard to aspire to.

Joe Marsh

Joe Marsh is managing editor of Capital Monitor and brings with him 25 years of investment and risk-management journalism experience.