George Bishay: Why impact bonds matter
Fixed income impact investment is a fast-growing but still relatively new segment of capital markets. Here Pendal portfolio manager George Bishay (pictured above) takes a deep look at impact bonds and answers questions we often hear from our clients.
EACH year, more and more sustainable bond investments become available, covering all aspects of the environmental and social spectrum.
There are bonds where companies in underlying projects reduce their carbon footprints and bonds that help finance companies with strong gender equality records.
Some bonds finance governments to build railroad and solar power plants, others help build affordable housing.
As the market rapidly grows, debate is intensifying about pricing and returns and how these bonds are trading in high-demand secondary markets.
More than $US465 billion of sustainable debt was issued globally in 2019 — a new record and up 78 per cent from the previous year. More than $US1 trillion in sustainable debt has been issued since the market began.
This growth is driven by soaring demand as investors seek ways to “do good” with their investments amid growing concern about climate change and social issues.
At the same time, corporations and governments are becoming ever keener to behave responsibly and to be seen doing so.
Types of impact bonds
There are two main types of impact bonds:
– Environmental bonds which finance projects that benefit the environment
– Social bonds which address a social need or improve an outcome for underprivileged people
Most of these bonds also adhere to the UN Sustainable Development Goals.
Why do companies issue impact bonds?
A key question we get asked is why corporations and governments issue impact bonds instead of traditional issuances. In our experience, they are issued for a number of reasons.
One reason is to signal confidence in the sustainability of a wider business.
Corporations issuing impact bonds are implicitly inviting scrutiny of their wider business practices and signalling they are confident in their sustainability credentials. This also leads to future benefits.
More and more traditional fund managers are incorporating Environmental, Social and Governance (ESG) factors into their investment processes.
This is partly because ESG risks genuinely affect performance and partly at the behest of end investors such as superannuation funds.
Companies that issue impact bonds are stamping their ESG credentials, which can ultimately be supportive of credit spreads they have to pay down the track.
A third reason is simply to cater for market demand.
Across the world investors are seeking access on behalf of clients to investments that are sustainable or make a positive change in the world.
Issuing impact bonds can also help diversify an issuer’s funding by attracting new types of investors.
Research also shows green bonds get the tick of approval from equity holders.
They can trigger a positive stock price reaction as markets react to expectations the bonds will improve long-term shareholder value by lifting company performance.
Examples of recent impact bonds include a $400 million, five-year bond issued by supermarket giant Woolworths to improve carbon emissions from refrigeration and lighting in its stores.
NSW TCorp, the bond issuer for the NSW state public sector, issued a $1.8 billion bond to further public transport projects and fund a sustainable water project.
Queensland’s QTC allocated bond proceeds to light and heavy rail projects, cycleways and a solar farm.
How do impact bonds perform?
It is true that impact bonds tend to perform well in the secondary market — but the reasons for this are nuanced.
We often say there is excellent secondary market liquidity for impact bonds if you’re looking to sell — but not so much if you’re looking to buy!
There should of course be no difference in pricing between impact bonds and their vanilla counterparts. This is true because the same credit risk applies to non-green bonds issued by the same issuer.
The credit risk is that of the issuer, not the underlying green or social projects.
This is most pronounced in bonds issued by supranationals such as the World Bank. The collapse of an underlying project has no effect on bond holders, who are assured by the triple-A rating of the World Bank itself.
Fundamentally, this also means investors are not penalised for investing in green bonds.
Investors in impact bonds get the same credit spread as if they invested in an equivalent vanilla bond from the same issuer.
Nevertheless, a “greenium” — a premium paid for green bonds — can be observed from time to time in the secondary market.
Often the explanation for the premium is simply an excess of demand over supply.
When Woolworths issued its first green bond last year it found demand five times stronger than its issue size and priced better than initial guidance. It traded even more strongly in the secondary market.
Whether this was demand for the green aspects of the bond — or simply demand for exposure to Woolworths — is difficult to determine.
But this differential can be a benefit for dedicated sustainable fixed income funds buying in the primary market. They are often handed a better allocation than a competing vanilla fund, putting them in an advantaged position in the secondary market.
During increased volatility at the end of the March 2020 quarter we saw one of our impact holdings do very well relative to a similar non-impact bond.
The bonds were issued by the National Housing Finance and Investment Corporation (NHFIC) — an independent Commonwealth entity that operates the Australian Affordable Housing Bond Aggregator.
This organisation provides cheap, longer-term secured finance for community housing providers by issuing bonds in Australia’s debt capital markets.
The funds raised by the bonds were loaned to community housing providers to help finance more than 2000 properties in Victoria, NSW, Queensland, Western Australia and South Australia.
This included supporting the supply of more than 360 new social and affordable dwellings.
The bonds, which typically trade in line with other supra nationals and semi-government bonds, outperformed in March 2020 as can be seen in the chart below.
The truly dedicated sustainable funds are not yet big enough to soak up all the impact bonds issued in Australia.
Some $6 billion of impact bonds were issued in Australia last year and the pure impact funds accounted for only a sliver of that supply.
This has the effect of keeping pricing in line with non-impact bonds.
Vanilla funds are required to fill the book and need to be offered at the same pricing as they would get in an equivalent non-impact bond.
Only when the dedicated sustainable sector is big enough to take out whole books will we start to see some difference in pricing.
Right now, that looks to be some way off.
George Bishay is a portfolio manager in Pendal’s Bond, Income & Defensive Strategies team.
George has managed dedicated Sustainable fixed interest portfolios for a decade. He has also worked across numerous fixed income, credit and money market portfolios in portfolio management, credit analysis and dealing roles for over 20 years.
In 2019 he was awarded the Alpha Manager status by Money Management’s FE fundinfo, in recognition of his career-long performance in the asset management industry.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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