Investors are beginning to seek independent audits of the sustainability targets of green bonds and social bonds as part of their bond covenants to ensure their investments are used for the intended purpose.
By their nature, the proceeds of green bonds and social bonds should be invested in environmental, social, and governance (ESG)-linked sustainable assets or activities of the issuers. But since sustainable investing is relatively new, the standards for adhering to ESG-linked targets and goals are still loosely based on the covenants of some green and social bond issues.
“You can’t just take each ESG-linked bond at face value,” says Marika Dysenchuk, fixed-income investment specialist at J.P. Morgan Asset Management. “You really need to do the research. And, ultimately, we need a check-and-balance approach. The next step is to have more independent oversight to make sure that issuers and companies are held accountable to meeting their sustainability goals.”
In line with this trend, investors are beginning to demand independent audit of the sustainability targets of green and social bonds. “We’re seeing increasingly that some issuers are embedding sustainability targets into their bond covenants and having an independent third party to hold them accountable to those targets,´ Dysenchuk notes. “What I mean by that is that, if they don’t meet their sustainability targets, their coupon will go up, and they will have to pay more interest.”
Although demand for sustainable investments has been growing in recent years, there has been a proliferation of green and social bond issues, particularly in the wake of the Covid-19 pandemic, as issuers began to raise financing to address the damage brought about by the pandemic. ESG-linked issues increased by 14% in 2020 with social bond issues, in particular, rising by 300%, although they admittedly started from a small base.
“ESG-linked issuances are bonds whose proceeds are directly tied to specific sustainability-related initiatives,” Dysenchuk points out. “That is really important for us as bond investors because it gives us that increased opportunity set to potentially invest in. But what’s really important is we still need to do the underlying work from a credit perspective, to make sure that we’re paid for lending that money and that yields are still attractive, and [coming] from a sustainability credentials perspective.’
“It’s like if you label an issue as a green bond,” she adds. “But when you actually dig into the covenants and into the details of what the company is committing to, or what they’re saying that they’re going to use the proceeds for, they are fairly vague. They’re not very specific on environmentally friendly initiatives. So, we want to really see that specificity and that detail around making sure our money isn’t just going to general use for the company, and that, when we lend that money, it is being tied to these specific initiatives.”
This approach is used by J.P. Morgan’s Global Bond Opportunity Sustainable Fund. The fund, which has a one-year track record and about US$700 million in assets under management, uses three pillars as part of its sustainability investment strategy.
The first is ESG integration, which ensures that its higher fixed income platform is considering ESG factors throughout all stages of the investment decision-making process.
The second is exclusion, which is applying both norms and values-based exclusions to the portfolio systematically, not investing in those activities or industries that are deemed to be unsustainable.
And the third pillar is referred to as “cosmic tilt”, which means actively favouring issuers that have better sustainability profiles or “cosmic momentum” on sustainabilities that gives an indication of where the companies stand today on their targets, which might not be the best, but gives an indication that they are moving in the right direction.
Dysenchuk states: “We look to invest in ESG-linked issues where we feel that we are both being compensated for them and that their sustainability credentials are robust.”