Evaluating labelled bonds: a robust framework is key

In recent years, the market for labelled, or sustainable, debt has continued to expand — with more than US$4 trillion estimated to be outstanding as of 31 December 2023¹ — as issuers face increased pressure from investors and regulators to finance a more sustainable future (Figure 1). 

Total sustainable debt issuance reached roughly US$830 billion, or 16% of total global issuance, in 2023. Notably, the sustainable debt market continues to benefit from new entrants to the market. Sovereigns, supranationals and agencies remain the largest issuers of sustainable debt; however, corporates are increasingly active — particularly in the financials space. 

Although sustainable debt issuance in 2022 and 2023 came down from the highs of 2021, this, in our view, is reflective of lower primary volumes resulting from rising interest rates and higher financing costs. Sustainable debt as a proportion of overall fixed income issuance continues to increase, a trend we expect to continue against a backdrop of improving bond structures as well as supportive sustainability policy and commitments.

Although, we have gained further confidence in the depth and quality of the sustainable bond market, we continue to advocate for establishing a robust framework to assess the suitability of labelled issuance for our fixed income impact portfolios, as outlined below. We also highlight how we can use our engagement edge to seek to combat greenwashing.

Labelled bonds at a glance

Use-of-proceeds bonds
With their key performance indicators (KPIs) and use of proceeds (UoP) outlined at issuance, green, social and sustainability bonds allow investors to target social and environmental objectives through their fixed income allocations, complementing traditional fixed income securities within an impact portfolio. 

We have also identified some secondary benefits that we believe further enhance the potential appeal of UoP bonds:

• Transparency: After issuance of green, social or sustainability bonds, issuers report on the exact projects to which the proceeds were allocated, the amounts, the impact and the achievement (or not) of targets. This helps us to verify, measure and report on the impact of our investments.
  
• Downside protection: In some periods of volatility, UoP bonds have not sold off as quickly as their non-green counterparts. While this may lead to a pronounced green premium in the secondary market, it highlights the potential for green bonds to exhibit stickier characteristics and offer more stable returns in periods of market stress.
  

Sustainability-linked bonds
Sustainability-linked bonds (SLBs) allow issuers to raise finance without ring-fencing the proceeds for a social or environmental project. Instead, they tie the future coupon payment to a sustainability performance target (SPT), which measures improvements in the borrower’s sustainability profile — for example, an overall reduction in greenhouse gas emissions associated with products manufactured. Some issuers have faced criticism for SLBs that lack robustness or incentive to allocate the proceeds with sustainable objectives in mind.

Nevertheless, we see a place for robust SLBs within our fixed income impact portfolios. We have identified some secondary characteristics enhancing their potential appeal:

• Accountability: SLBs offer an alternative mechanism for companies to prove their commitment to sustainability. With coupon payments tied to the achievement of a target, SLBs impose a direct financial penalty on the issuer if their target is not met.
• Flexibility: SLBs give issuers greater flexibility than UoP bonds. They allow more types of issuers — including those whose products or services don’t have a direct social or environmental impact — to enter the sustainable debt market and thereby facilitate a larger collective effort towards increasing the sustainability of more issuers’ operations.
  

Building a framework 

We recognise that labelled bonds are a useful part of the public debt market toolkit in the pursuit of generating impact. We have developed a labelled-bond framework that aims to ensure we stay true to our commitment to high-integrity fixed income impact investing and combatting greenwashing. Below, we outline our best practices.

UoP bonds
1. Threshold for use of proceeds
Without standardisation in the labelled-bond market, the percentage of proceeds allocated to social or environmental projects varies. To maximise the materiality of our investments, we favour bonds where over 90% of the proceeds are to be allocated to eligible projects.

2. Lookback period
Some UoP bonds are issued to refinance an existing or historical project. While we accept some exposure to refinancing for long-term projects, we typically have a maximum lookback period of two years. This ensures our financing is tilted towards new projects.

3. Sustainability of operations
Some sectors are excluded from our investable universe, as we believe they are fundamentally misaligned with our impact objectives; we will not invest in UoP issuance from issuers in these sectors. Where an issuer’s business model does not qualify for impact, but we approve at the security level, we consider the sustainability of their operations/business practices in our investment process.

4. Valuation
Once we have determined whether a bond is eligible for our investment universe, fundamental analysis ensures that the bond is suitable according to the risk and return targets of our portfolios.

Sustainability-linked bonds
SLBs’ more flexible structure, combined with a lack of regulation, creates opportunities for greenwashing. We pay close attention to SLBs’ structure to ensure that the issuance aligns with our high-integrity approach:

1. Sustainability performance targets
We favour issuers with ambitious SPTs and meaningful financial penalties for missing future goals — for example, via a coupon step-up. We avoid issuers that set targets that are in line with what the issuers were planning to achieve through their ordinary business activities or have minimal penalties, such as a step-up that is small or implemented late in the coupon payment cycle.

2. Consistent KPIs
We favour issuers that use consistent KPIs to monitor progress towards an SPT. We feel issuers should report historical KPI levels, use consistent base rates and be held accountable through engagement and potentially divestment if their KPI reference changes.

3. Sustainability of operations
As with UoP bonds, we will not invest in SLBs from issuers in sectors that are misaligned with our impact objectives.

4. Valuation
As with UoP bonds, it’s critical to assess financial characteristics to determine suitability according to portfolio risk and return targets.

Our engagement edge

Our labelled-bonds framework is complemented by Wellington’s Fixed Income Syndicate Trading desk, which benefits from its relationships with the sell side. Through our engagement, we highlight structural deficiencies in labelled-bond offerings to be communicated to the issuers through their advisers. We also meet each issuer during the pre-marketing phase of a future deal and advise how to robustly structure a sustainable bond. Engaging in dynamic discussions both on the structure of sustainable debt issuance and on specific ESG-related questions allows us to develop a fuller understanding of the issuer’s approach to sustainability and identify whether it is serious about working towards its sustainability goals.

Below, we highlight three examples of our engagement:

Closing thoughts

We expect the labelled-bond market to keep growing, given the continuing establishment of carbon-reduction commitments by corporations and governments and increased demand from investors. This evolution will pose challenges for investors using an ESG or impact lens.

While robust regulation in the relatively new labelled-bond market remains lacking, the EU’s European Green Bond Standard — a voluntary, high-quality standard for green bonds due to be implemented in December 2024 — should increase the transparency and robustness of green issues. The same principles could also be used to develop a social and sustainability bond standard, leading to greater uniformity across sustainable debt issuance. Conversely, the European Green Bond Standard could reduce the appeal of existing green bonds that don’t meet the standard. This could create a “haves versus have-nots” pricing dynamic, incentivise stronger, more ambitious terms and support the transition to a sustainable future.

Irrespective of regulation, we believe that it is essential for responsible asset owners to have a robust framework for analysing labelled issuance and that this will ultimately help to establish higher ESG standards in the market and increase the likelihood of generating real-world impact.