There are three reasons to be optimistic writes Johann Plé, Green Social and Sustainability Bonds Strategy Manager at AXA Investment Management
Last year was a very challenging year for the bond market and sustainable bonds were no exception. Yet, there are reasons to remain optimistic about the asset class looking forward; the green bond market shows resilience and offers interesting investment opportunities which continue to drive investor appetite.
While uncertainties remain high, there are growing signs that headline inflation is abating, that growth is coping better than expected and that central banks’ tightening cycle might soon come to an end. This context should be particularly favourable to the Green, Social and Sustainability (GSS) bond market.
As regulation steps in and strengthens scrutiny over sustainable investment, GSS bonds should further benefit from the transparency they provide.
Green bonds are fulfilling their primary role of financing projects with a positive impact on the environment while also offering investors a market that is liquid and growing in its potential to achieve large tradeable volumes.
We see three reasons for optimism for the green, social and sustainability bond market.
1. A very dynamic market
Amid turbulent economic conditions in 2022, green, social and sustainability bonds still registered $606 billion of new issuances and welcomed an additional 115 new issuers.
Credit accounted for more than 50% of total issuances for the third consecutive year, thanks to an increasing sector diversification coming from the real estate, automotive, consumer goods, or telecommunication sectors.
Meanwhile, sovereign issuance continued to pick-up, with new countries such as Austria or Canada issuing their first green bonds. This reflects not only the credibility of green bonds when it comes to support the financing needs of the Net Zero transition, but also that sectors are progressively investing in such transition.
Looking ahead, there are reasons to believe that this sector diversification should also be accompanied with greater regional diversification. One could expect higher issuance for US corporates, especially on the back of the US Inflation Reduction Act, while Emerging issuances should continue to pick-up as a successful global transition cannot be achieved without significant investment in the area.
Also read: How to Invest in Bonds – Getting Started
The Social and Sustainability bond market dynamic was a bit more nuanced. Yet, it is worth highlighting that we saw the first social bond issuance from a Real Estate issuer, potentially paving the way for more corporate issuances in the segment. Meanwhile, digging into the sustainability bond dynamic, it is worth noting the strong contribution of USD issuances compared to Green and
Social bonds which remain dominated by EUR issuances. These dynamics continue to bring a wide range of diversified investment opportunities from both a sector and geographical perspective.
2. …with attractive valuations
The rebound in yield levels at the end of 2022 has helped valuations to look increasingly attractive. The long-term picture looks more and more compelling for the bond market and should be particularly beneficial to GSS universe given its credit exposure and sensitivity to interest rates.
The GSS universe currently enjoys an attractive yield pick-up compared to the conventional universe and looks better positioned to benefit from a decline in yields and compression of credit spreads.
3. Tougher regulatory pressures and increasing climate and social awareness should continue to drive interest in this asset class
Sustainable strategies have benefited from growing investor appetite over the past years. As regulation steps in, it is crucial to be able to continue to demonstrate the credibility of these strategies. GSS bonds offer a very appropriate instrument that combine transparency and measurability of the projects funded. We believe this should be particularly beneficial to the asset class and attract both new investors and new issuers.
The transition to net zero requires massive investments over the coming years. For example, a recent study showed it would require an extra $3.5 trillion a year in capital spending on physical assets for energy and land use systems to succeed by 2050. Initiatives such as RePowerEU or the Inflation Reduction Act in the US are likely to support these investments and should be beneficial to GSS bonds.
On the social side, cost-of-living related challenges are exasperating the inequalities across populations. Alongside this, low-income households in developed and developing countries are on the front line when it comes to bearing the cost of both climate change disasters and a transition to net zero.
If the perspectives are positive for the market, investors should nevertheless remain cautious when investing in sustainable bonds. The crux is the ability of asset managers to invest in meaningful projects from credible issuers though a strong analysis. The capabilities of the asset manager are key here and this is why at AXA IM we have developed a powerful GSSB framework that allows us to be very selective on this market.
Last but not least, investors need to closely follow and contribute to the evolution of regulation pertaining to the upcoming green then social taxonomies, how they will work with Europe’s SFDR regulation. We will all need to adapt, but these should not impede our increased ambition to contribute to a green and just transition.
How liquid is the green bond market?
The green bond sector has grown to be a US$1 trillion+ investable market that has seen a sharp uptick in diversification on the credit side and an increasing number of sovereign issuers.
It is evolving as a mature sector, with granularity and depth, but this hasn’t robbed it of idiosyncrasies. Most prominent is perhaps the so-called ‘greenium’ – the idea that excess demand can drive lower yields.
We have found that the greenium is, in fact, an uneven and perhaps exploitable phenomenon for active investors. But it does raise another question: Do those potential supply-demand imbalances mean there may be liquidity issues in green bonds compared to the conventional bond market?
Digging into the liquidity profiles of the two markets, we found that both trade with a similar difference between the highest someone is willing to pay and the lowest a seller is willing to accept (the bid-ask spread), with slightly lower volumes in green bonds. But there is more to the story than that.
To compare the liquidity of the green and conventional universes, we have focused on two dimensions:
- the average bid-ask spread observed on each security; and
- the Bloomberg liquidity score.
The Bloomberg Liquidity Assessment (which runs low-to-high from 1-100 and is known as LQA) aims to quantify and compare the liquidity of securities based on their respective trading cost for a comparable range of volumes. We will look at both metrics through different breakdowns (currency or sector level) and from both a weighted and unweighted perspective so that we can even out any differences in segment exposure.
Comparing universes
To examine the segments, we used the ICE BofA Green Bond Index (GREN) and ICE BofA Global Broad Market Index (GBMI) and focused on the euro and US dollar as the most representative of the green bond universe. We also excluded securitised debt, which is rare in the green bond universe, and ignored market weights.
We observe that the weighted average bid-ask spread of green bonds looks smaller than that of conventional bonds. The conclusion is the same when rebalancing euro and dollar in both universes (unweighted average at 0.30% versus 0.34%). Yet the liquidity score that takes into account tradeable volumes, provides a valuable insight as it looks similar for both green and conventional bonds (weighted or unweighted average around 48). One could assume that this means green bonds do not bear any additional transaction cost but exhibit lower transaction volumes than conventional bonds.
It is already interesting to see that the euro segment, the one offering more granularity, tells us a slightly different story with a comparable bid-ask spread and a lower liquidity score.
The green bond universe is dominated by euro-denominated debt, mostly corporate and quasi-sovereign, while the conventional universe is dominated by dollar issuance, mostly by sovereigns. Hence, we think a more reliable approach would be to correct both universes’ biases in order to have a more accurate comparison basis.
Despite the growth of the green bond universe and the arrival of inaugural issuers joining the market every year (circa 100 in 2022), there is still a significant difference in the number of active issuers compared to the conventional universe.
In our view then, the cleanest approach to properly compare green and conventional bonds is to focus exclusively on issuers that have already issued at least one green bond.
This additional filter particularly benefits the conventional bond universe. Indeed, the average bid-ask spread is significantly reduced and converges towards the average bid-ask spread observed for green bonds. This seems relatively consistent with the fact that we are now looking at the same issuers across both universes and ignoring weighting differences. In the meantime, the liquidity score is boosted above that of the green bond universe. This is certainly consistent with the fact that outstanding conventional debt is at a higher level than the outstanding green debt.
Green bond liquidity is not an issue
This brings us back to our initial observation of the euro green bond segment that showcased an equivalent bid-ask spread for a lower liquidity score. There are several insights to draw.
First, euro issuance is a very accurate proxy for the universe and can provide a good picture of what to potentially expect in terms of market dynamics and liquidity for other currencies as the green bond sector progressively expands.
Second, green bond issuers tend to be more liquid than non-green issuers.
Finally, at issuance level, there is no additional transaction cost of trading green bonds compared to conventional bonds and yet daily tradable volumes remain lower.
