Up until very recently, the labeled bond market was the domain of larger issuers with better credit ratings. But now the market for sustainable high yield is really taking off. More high yield companies are looking to the labeled bond market to showcase their sustainability efforts. Is this an encouraging development or does it open the door to greenwashing? APG is enthusiastic but remains selective in its approach. “Our aim is to ensure there is transparency, accountability and true impact.”
As recently as a year ago, there were very few labeled high yield bonds outstanding. “But as the long-term performance benefits of incorporating ESG factors into business operations become clearer, more companies are now looking to the labeled bond market to showcase their sustainability efforts,” says US Credit analyst Joshua Linder. In 2021 to date, over 60 high yield labeled bonds were issued in Europe and the US. It is an indication that the high yield labeled bond market – including green, social and sustainable bonds as well as sustainability-linked bonds - is really taking off.
High yield companies increasingly issue bonds with a sustainable label
In the low-yield environment of recent years, the high yield bond segment has offered attractive returns and important diversification benefits. High yield bonds pay investors a higher level of interest to compensate for a higher degree of risk. In 2021, an increasing number of high yield companies have sought to attach environmental, social or governance (ESG) ambitions to their financing by issuing bonds with a sustainable label, says Sven Smit, who manages a portfolio with euro-denominated high yield bonds. “The labeled bond market has ceased to be the almost exclusive domain of larger issuers with better credit ratings.”
As an active investor in labeled bonds and major participant in the high yield bond market, APG is enthusiastic about these developments. “But we are also selective in our approach,” says Linder. “There are no short cuts. We thoroughly research every labeled bond deal and issuing company in order to avoid greenwashing.”
Sustainability-linked is the label of choice in high yield
Research published by Deutsche Bank suggests that labeled bonds now account for around €45 billion or around 9% of the European high yield market (including financials). While US dollar issuance so far this year is around $21 billion, a little over 4% of total 2021 issuance according to JP Morgan. Smit: “Diversity is also improving with healthcare, industrials and manufacturing, representing roughly 40% of outstanding labeled bonds in Europe.” About one third are green bonds and the rest are social, sustainability or sustainability-linked bonds (SLBs). “In the US high yield market, we see a nice mix of issuers across sectors with about 30% opting for the SLB structure,” says Linder.
But why the relatively high percentage of SLBs in high yield? “Basically, it is because the structure of an SLB is often a better choice for a smaller company and high yield issuers tend to be smaller,” explains Smit. Labeled bonds can be divided into two basic categories. There are those with a structure that earmark the funds raised by the bond issue for specific pre-determined projects. Green and social bonds, for example, fall into this category. The other structure, of which SLBs are the most popular form, enable companies to align issuance with their overall corporate sustainability strategy, by setting sustainability targets in the form of key performance indicators. “This is often a better fit for a high yield company with ambitions to improve on sustainability but too small to be able to raise funds via a bond to finance specific green projects,” Smit concludes.
Alert to greenwashing, but proactive in financing change
APG has strict internal guidelines for all labeled bond investments, but is there more risk of green washing with high yield issues? “We evaluate all labeled ESG bonds in the same way across different parts of the bond market. Our aim is to ensure there is transparency, accountability and true impact,” says Linder. “In that sense, for us the risks associated with high yield are not greater.” However, although the structure of SLBs ensures issuers are penalized with higher interest costs if they fail to deliver on their KPIs, having less oversight on what the money is actually being spent on does increase the potential for greenwashing in general. “It’s a sort of balancing act,” explains Linder “We have to remain extra vigilant around these SLB deals, but the flip side is that this gives us a golden opportunity to help companies make progress on their transition strategies. As a leader in responsible investing, we also have an important role to play in helping maintain the integrity of the market.”
In 2021 to date, in European high yield, APG has participated in 12 out of 16 SLBs and 9 out of 24 green bonds that were issued. In the US there have been around 23 developed market labeled bond deals so far this year and APG has participated in 8 of them (5 green, 2 SLB, and 1 social). “Although we passed on some of the bond issues for portfolio and valuation reasons, there were also a number that did not fulfill our requirements in terms of the issuer’s bond framework, the bond’s structure or the KPI targets,” explains Smit. “When this happens, we try to be clear to the issuer about why the bond doesn’t meet our standards and what our expectations are so that in future improvements can be made.”
Joining with other stakeholders to help companies raise the bar
There are various reasons why issues may not fulfill APG’s investment criteria from a sustainability perspective. Smit: “For example, we passed on a green bond issued by an industrial and energy company because the money being raised was earmarked to refinance an earlier ‘grey’ bond issue rather than for any green project purposes”. APG also chose not to invest in a SLB from a US telecom issuer because one of the KPI targets it set for the bond had already been achieved. “This undermines the intent and purpose of the SLB market which should be forward looking in nature and stimulate sustainability ambitions,” says Linder.
APG also invests time in helping companies work towards a credible sustainable issue often together with the banks who arrange the financing. “For a US company in the financial services industry, we engaged with the management team for over a year, helping the issuer develop a comprehensive social bond framework,” says Linder. “We were then delighted to be able to invest in the resulting bond issue, which targeted improving access to responsible financial products and services for vulnerable and/or underserved populations.”
Looking ahead – challenges and opportunities
Although this market is rapidly gaining momentum, there are still challenges ahead. “Further fragmentation as a result of new ‘flavors’ or bond structures is a cause for concern,” explains Smit. “If new product types are not well regulated with rigorous reporting standards, they open the door to greenwashing. Having too many labels can also damage the credibility of the market as a whole.” Another issue to be wary of is the fact that high yield bond structures often offer the issuer an option to refinance early. If this call date occurs before the KPIs have to be achieved, it obviously defeats the object of having targets.
But overall, the prospects look bright. The combined benefits of attractive returns and an increasing focus on sustainability in high yield, will further boost investor demand. Linder: “What’s more, companies that issue labeled bonds to finance sustainability improvements can inspire their peers to do the same, helping to raise the bar for ESG performance and governance for high yield bond issuers across the board.”