NN Investment Partners’ green bond offering has this year been boosted by an increase in sovereign activity, while social developments may have opened a gap in the market, according to Douglas Farquhar, client portfolio manager for green bonds, NN IP, even if its reservations about sustainability-linked bonds (SLBs) persist.
Shruti Khairnar, Sustainabonds: As an investor, what are the key pros and cons of the EU Taxonomy, particularly when it comes to reporting?
Douglas Farquhar, NN Investment Partners (NN IP): With the taxonomy, we now know how an activity can be green, all the way from the issuer to the investor to the regulator. That’s a major plus for us in terms of the amount and reliability of the industry information that’s available.
At the moment, there’s a little bit of guesswork required in terms of whether an activity is green, and the taxonomy gives us a clear standard that is harmonized, so that everyone is using the same definitions. It will also push companies to be a lot more transparent than they would have been before on non-financial disclosure. So we do see a lot of pros with the taxonomy.
The cons for reporting are pretty limited because we do have a lot of the data already that we track for the bonds and for the issuers, so we are pretty much ready to report against whichever metric ends up being chosen.
However, there’s going to be a bit of a challenge in terms of data availability from the EU taxonomy databases, because a lot of data is not readily available and produced by outside research teams, and they haven’t got the information themselves in order to populate those databases. So we think this data availability issue is going to make assessing EU taxonomy alignment an issue for most asset managers at the moment.
The other con with the taxonomy is that it’s still being developed. There are a number of sectors that still need criteria, like telecommunications and textiles. Also, some of the six segments within the taxonomy still need to be fleshed out. While we understand it’s going to develop over time, I think its true impact is probably only going to be seen in a few years when we really start to observe robust reporting from issuers, from companies, and also from asset managers in terms of bond fund level.
Khairnar, Sustainabonds: The European Commission is also consulting on the proposed voluntary EU Green Bond Standard. What are the prospects for this?
Farquhar, NN IP: We don’t think it’s going to have a big impact immediately. In our case, we would still accept what is currently done, which are the second party opinions associated with green bonds. And we don’t rely exclusively on those, because we do our own assessment. So, I wouldn’t expect us to move to only accepting bonds certified under the EU Green Bond Standard – there are still going to be some bonds that fit our criteria that aren’t in the EU taxonomy just yet. I’ve already mentioned textiles, telecommunications, and we would also still accept green bonds for buildings where the greenness is assessed through building certification programmes, rather than the EU taxonomy requirement of the top 15% of the market.
It’s great if a bond issuer wants to come out and say that they’re 100% aligned with the EU taxonomy – and the “do no significant harm” additional element is very, very useful – but it is going to be a couple of years before we see bonds with the EU Green Bond Standard certification becoming the standard.
The other challenge that we see with the EU Green Bond Standard is that it’s still very much an EU-driven approach in what is a global market. It would be really interesting to see what the regulators do in other countries, specifically those who said that they will follow the EU taxonomy, and if they also follow the EU Green Bond Standard in terms of the certification approach.
The final aspect is what it means to the cost of issuer. At the moment, the cost of a second party opinion is very negligible, given the scale of the debt that’s being issued, and is certainly not a barrier to getting a bond labelled as green. Do we see those approved certifiers start to raise their fees for EU Green Bond Standard certification? Does that become a barrier for some issuers? It would be interesting to see how that develops as well.
Khairnar, Sustainabonds: The EU has plans for a separate social taxonomy, while NN IP appears to focus more on the green aspect than the social aspect. Is there a reason behind this, and would a social taxonomy nudge you in that direction?
Farquhar, NN IP: It’s fair to say that we’ve primarily focused on green so far, and that has been because the green bond market is further along in its development – it’s much more diversified, much bigger in terms of total size, and market standards have evolved over time.
We are actively looking at social bonds now. It was a very small market prior to last year, with total issuance of €57bn at the end of 2019. However, when you look at how much issuance we’ve seen in 2020 and in particular 2021 year-to-date, it’s a fast-developing market. So we continue to monitor it. It still lacks a little bit of diversification, in terms of being quite dominated by government-related issuers – you don’t see many corporate social bonds.
We are working on our own criteria for social bonds, and the development of a new EU social taxonomy – in the same way that we’ve integrated the EU green taxonomy – will be good, because with social, it’s even harder to get consensus on what the criteria will be. This is particularly true with social bonds, because you don’t just have the category of proceeds; you also have to identify what segment of society is going to benefit from the disbursement of those proceeds. However, I don’t think in our case we need to wait for the social taxonomy.
So it’s definitely a market we’re monitoring with a lot of interest. We don’t see a lot else out there from other asset managers in terms of pure social bond funds, so we do think there is a gap. What we’re doing at the moment is talking to investors to understand if they want to make an allocation to social in the same way they’ve done with green, to what extent that would be, and once we’ve completed that process, we’ll be able to make a decision whether we launch a social bond fund or not.
Khairnar, Sustainabonds: It seems NN IP is not a big fan of sustainability-linked bonds. What are the flaws of the product, and what would persuade you to embrace them?
Farquhar, NN IP: We have a couple of reservations with the specific structure of sustainability-linked bonds. At the moment, the way in which they’re designed is that the issuer gets the benefit of the lower cost of capital, lower cost of debt, upfront, and only if they fail to hit the sustainability-linked targets do you see the coupons step up.
We prefer it the other way around – you pay the same yield that you would normally do, and then you get a step down on the coupon as and when you achieve progress towards the sustainability targets. We think that makes more sense because the issuer is improving their ESG risk profile, they’re reducing their exposure to ESG risks, and by doing so they could get a lower cost of debt. And we have seen two examples of bonds that have operated in that way, with a coupon step-down rather than a step-up.
The second remark is related to the level of coupon step-up/down. At the moment, the standard is about 25bp, either once over the tenor of the bond or in some cases twice. That is a very cheap cost to pay as an issuer to get yourself out of trouble if you fail to hit your sustainability-linked targets. So we would like to see a more meaningful coupon, and that’s a benefit to issuers, too.
Third, is the information asymmetry. Green bonds, sustainability bonds and social bonds are very transparent to us as an investor. With sustainability-linked bonds, the issuer is always going to know far more about the baseline data that they’ve chosen to set their performance targets against and how ambitious those targets are, and how likely it is they’re going to hit those targets. So there’s an information asymmetry that we as an investor would need to find a way to overcome.
And that’s also linked to the transparency on the proceeds. In order to cooperate on impact reporting, we need to know what the bond proceeds are being spent on and with the sustainability-linked format, they are general corporate purposes, as long as they contribute towards the sustainability-linked metrics. So we don’t know the specific projects and assets that are being financed. More transparency around how the proceeds are being disbursed, and some greater transparency on the data that’s being used as baseline and target-setting would also be an improvement in terms of that specific structure.
Khairnar, Sustainabonds: You recently launched a sovereign green bond fund. What was the rationale behind this, and how much interest have you seen?
Farquhar, NN IP: The rationale behind it really was to complete the range of options for investors. We have the aggregate fund, a short duration version, and a corporate-only version. Some investors only allocate to sovereign and government-related issuers, so by launching the sovereign green bond fund, we have a product that meets their needs.
It’s also something that investors can mix with the corporate fund if they want an allocation that’s different from the aggregate benchmarks or if they want more corporate or more sovereign than you see in the aggregate benchmark. They can mix to their preferred levels, and it’s really useful for us to be able to offer our clients that full range of options.
We’re also seeing a lot of new issuance – we saw Italy come to the market with their debut green BTP, we’re going to see debut green UK Gilt and debut green Spain sovereign bonds in September, as well as the EU green bond issuance as part of their Next Generation EU programme, which is going to be €250bn of green bonds over the next few years. So it’s a rapidly growing segment, and we’re going to see further diversification, and that was also part of the rationale as to why we launched the fund.
We started with assets under management of €135m, and we’re up to €174m since being launched at the end of March, so we have seen some interest. However, one of the challenges with sovereign green bond benchmarks is its duration is just under 12 years, so in a rising rate interest rate environment, that’s not necessarily a product that’s going to be very, very popular.
Khairnar, Sustainabonds: What are the specificities of green sovereign bonds and the fund?
Farquhar, NN IP: We don’t have a pure treasuries benchmark; it’s treasuries plus supranationals, local agencies and municipalities – which does mean you get a better yield. If you look at the yield on the non-green sovereign benchmark, it’s around 4bp, whereas the yield on the green benchmark is 27bp, so you get a bit of yield pick-up. However, as I mentioned, the duration is a bit longer – just under 12 years, versus 8.7 years for the non-green benchmark.
The other thing is, although it’s a global benchmark, at the moment it is very dominated by European issuers. That is primarily because it is a euro benchmark, but in the corporate segment we do see global issuers, primarily North American and Asian green bond issuers issuing in euros because that’s where they see the investor demand. We understand that’s a bit of a harder sell for them sometimes within their individual countries. It’s something that we’ve engaged with the UK on in relation to their green Gilt. They have committed to issue multiple green Gilts at multiple points along the curve, and we would like to see issuance not just in sterling but also in euros. We can hold off-benchmark positions in non-euro currencies, but more issuance from outside the Eurozone would be really good in terms of diversification for the sovereign segment.
Khairnar, Sustainabonds: What are you parting thoughts on the future of this market?
Farquhar, NN IP: We’ve seen so much growth this year after what was a relatively flat year last year. We have already passed total issuance for 2020 at the end of June this year. That’s caused us to increase our growth projection for this year to €400bn of green bonds, which would take the green bond market above €1tn and we expect to see it continue to grow.
So far this year, about 18% of all European euro-denominated investment grade bonds have had some form of label – green, social or sustainable – up from 14% last year. So not only are we seeing growth in the market, but we’re seeing a greater percentage of all European investment grade bonds being issued as some kind of impact bond. And if we’re going to really tackle climate change, as well as some of the social issues that we’re wrestling with as a world, it’s really important that that capital gets put to work addressing those issues, and the growth of this market is a demonstration of that.
Global green bond issuance (in EUR)
Data and main image source: NN IP Green Bond Funds Impact Report