Bonds making an impact
The market of green, social or other sustainability-labelled debt was not immune to the wider market conditions of 2022, according to Insight Investment1 . Here the group explains why impact bonds are likely to see a resurgence in 2023.
There was a noticeable slowdown in new issuance of impact bonds in the second half of the year, resulting in an overall fall year-on-year from record growth in 2021 from around US$1.8 trillion to US$1.5 trillion.2 Nonetheless, a number of corporate sectors and regions (particularly in Asia-Pacific) have continued to see issuance growth in 2022, thanks to enduring investor demand for these instruments versus consistent undersupply. Agencies and governments have also been supportive of issuance over the past year.
We expect these trends to continue in 2023, with a return to year-on-year issuance growth, albeit with a growing focus on quality over quantity of holdings as a result of heightened regulatory and investor scrutiny, particularly in Europe. Our forecast points to strong growth in corporate issuance – particularly in North America and Asia Pacific – offsetting slower growth in issuance by financial institutions, agencies and government issuers in 2023.
In particular, the policy push towards rapid deployment of low-carbon energy in many regions in 2022 is expected to be supportive of renewed energy-focused corporate issuance in 2023 in key markets such as the US, EU and Japan. More broadly, a stabilisation of market conditions and interest rate changes in 2023 are likely to give issuers confidence to bring existing project pipelines to market in the first half of the year.
Figure 1: Insight expects sustainable debt issuance to regain momentum in 2023
Source: Insight Investment, Bloomberg Intelligence.
Growing standardisation and transparency likely to shape the market
- Cost of issuance
We see some headwinds to growth in 2023, not least the wider regulatory push towards standardisation and crackdown on greenwashing in many jurisdictions, which could drive up costs of issuance. While historically, green mandates and undersupply of suitable instruments have shaped investor demand for impact bonds, we see growing signs of sensitivity to transparency and quality of reporting on bond proceeds. Instruments that can demonstrate alignment with the EU Green Bond Standard, for example, will gain market access among some investors, albeit with higher associated costs of structuring, issuance and ongoing reporting.
- External verification of impact bond frameworks
While increasingly commonplace within European issuance, external verification remains less widely employed in other regions, particularly the USA and China. Nonetheless, we expect to see some convergence with European trends over 2023. Major US issuers of green bonds such as Berkshire Hathaway have recently begun to publish reports on allocation of proceeds from these instruments for the first time, indicating rising investor demand for transparency.
Similarly, the US dollar-denominated Chinese green bond market (which is dominated by state-owned financial institutions) is coming under growing pressure from overseas investors to improve transparency and reporting on allocation of proceeds. China published its national Green Bond Principles in July 2022, which are closely aligned with international standards such as the EU Green Bond Standard and aim to address a previously fragmented domestic market. Despite this, state-owned enterprises can allocate up to 50% of green bond proceeds to non-green activities.
- Emerging markets set to benefit
Emerging markets are likely to be key beneficiaries of market stabilisation, standardisation and renewed growth of the impact bond market owing to the range of environmental and social investment needs in such markets, and key sovereign issuers such as India are expected to issue green bonds in 2023.
Impact bonds may be moving towards a two-tier market in terms of frameworks
Our in-house assessment of impact bonds shows that while the share of such instruments receiving a ‘dark green’ best-in-class rating has fallen in recent years, alongside an increase in ‘red’ ratings, the share of ‘light green’ ratings that meet our sustainability and disclosure requirements for such instruments has remained stable. This is despite a sharp increase in the variety of issuers bringing such instruments to market in recent years, across diverse sectors, geographies and sizes. Demand for green bonds has remained strong for many investors, but there are signs the market may be moving toward a two-tier system, with rising demand for frameworks meeting the highest standards of reporting and disclosure among some and demand for lower-cost, more limited frameworks among other investors.
Figure 2: Insight’s ratings of impact bonds show a fall in ‘best-in-class’
Source: Insight Investment, 31 December 2022.
Demand is likely to focus on use-of-proceeds bonds rather than sustainability-linked debt
The push towards greater transparency and standardisation should be supportive of use-of-proceeds structures (such as green bonds) at the expense of more flexible structures such as sustainability-linked bonds. The past year saw a fall in the popularity of sustainability-linked bonds, particularly among financial institutions, where their variable coupon structure is at odds with regulatory capital requirements in many jurisdictions. More broadly, there is growing concern around the underlying integrity of ESG outcomes from such instruments, particularly given typical incentives for meeting key performance indicator targets under such structures.
The use of sustainability-linked bonds for general use of proceeds appears to be increasingly at odds with investor and regulatory expectations for greater clarity and consistency of allocation of proceeds to environmental and social outcomes. Nonetheless, we believe these instruments will still have a key role to play in channelling transition finance to ‘high impact’ activities that may be less suited to use of proceeds structures. We expect growth in issuance among some corporate sectors alongside a similar push for standardisation and transparency from market participants and regulators.
The value of investments can fall. Investors may not get back the amount invested.
1 Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.
2 Source: Bloomberg. As at 31 December 2021.