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AllianceBernstein: Making Sense of ESG-Labeled Bonds

AllianceBernstein: Making Sense of ESG-Labeled Bonds

Published 03-30-22

Submitted by AllianceBernstein

Analysis is for illustrative purposes only and is subject to revision. As of February 22, 2022 KPI denotes key performance indicators; ICMA denotes International Capital Market Association; GBP denotes Green Bond Principles; and SBP denotes Social Bond Principles Source: AllianceBernstein (AB)
Analysis is for illustrative purposes only and is subject to revision. As of February 22, 2022 KPI denotes key performance indicators; ICMA denotes International Capital Market Association; GBP denotes Green Bond Principles; and SBP denotes Social Bond Principles Source: AllianceBernstein (AB)

Salima Lamdouar| Portfolio Manager—Sustainable Fixed Income

Tiffanie Wong, CFA| Director—Fixed Income Responsible Investing Portfolio Management; Director—US Investment-Grade Credit

We’re optimistic that securities labeled as environmental, social and governance (ESG) bonds will help create a better, more sustainable world. And investors are just as eager to buy these bonds. But with the recent proliferation of ESG bond structures, the investment landscape has become more complex—and potentially confusing.

Assessing an ESG-labeled bond means delving deeper than an issuer’s financials, into the bond’s governing framework and its fit with the overall sustainability of the issuing company. In other words, to make the right investment choices, investors must understand the different structures and their investment implications.

Many investors are already familiar with green bonds, which have been on the market since 2007. Green bonds finance a specific project or projects with an environmentally beneficial purpose. Since then, companies have issued new types of bonds to finance a range of green, social and sustainable projects (Display).

The most recent innovation—the sustainability-linked bond—is a target-based structure incorporating key performance indicators (KPIs). It incentivizes the issuing company to achieve higher ESG standards across the business, rather than to finance a specific project. Such initiatives give issuers considerable flexibility in raising capital on ESG-linked grounds.

The proliferation of ESG-linked bonds means investors need to be aware of the technical distinctions and the investment implications of each type.

Project-Based Structures

Despite the growing popularity of more recent structures, green bonds are still the biggest class of ESG-linked finance, with more than $1 trillion outstanding, according to the Climate Bonds Initiative. We like this structure because it supplies a clear link between capital investment and improving the environment, and it works well for many industries.

Even so, there are several intricacies that investors should bear in mind. Proceeds for each issue are meant to finance a green project (or range of projects) in line with a specified framework and timeline. But bondholders cannot force the issuer to use the proceeds for the stated projects or to deliver them on time. Effectively, investors in green bonds are relying on the reputation of the issuing company and must have confidence in its credentials.

Importantly, investors should be sure that the issuer’s projects are genuinely environmentally beneficial and not misrepresented, or “greenwashed.” That means verifying that the metrics established for a project’s impact report are specific, material and credible. For example, investors might determine whether a project that aims to reduce CO2 emissions will do so by a meaningful amount.

One development that helps frame certain types of impactful projects comes from Europe. The European Union (EU) has created a detailed taxonomy for sustainable activities that investors can refer to when authenticating green bond issues related to climate change mitigation and adaptation. Whenever possible, green bonds’ use of proceeds should align with the EU taxonomy. For euro-area companies—particularly high-yield issuers—that have been shy about issuing green bonds, this is welcome news, as the taxonomy allows them to identify green assets more easily.

We are closely watching similar developments in other regions, such as China. In the meantime, the leading index providers have established their own tests to determine whether bonds are genuinely green, though these can be subjective and aren’t exhaustive. As a result, inclusion in a green bond index doesn’t prove that a bond is truly green.

Social bonds work the same way as green bonds but finance socially impactful projects. Examples include new buildings for communal benefit, educational programs for an underprivileged demographic and more hospital beds for low-income areas.

We saw a resurgence in activity in this asset class in 2020, with issuers such as Italian national agency Cassa Depositi e Prestiti using this structure to help respond to the COVID-19 emergency and sustain the recovery of the Italian economy and communities.

Other project-based structures include sustainability bonds and sustainable development goal (SDG) bonds. Use of proceeds for sustainability bonds falls into both social and environmental categories, while for SDG bonds, the pool of eligible assets can be wider and align with one or more United Nations SDG.

Just as with green bonds, investors need to do due diligence on all project-based bond issuers and the credibility of their projects.

Target-Based Structures

The proceeds of sustainability-linked bonds (formerly called KPI-linked bonds) are meant for general corporate purposes, not for a specific project. 2021 saw a big uptick in this kind of issuance, as flexibility around use of proceeds opened the door for many high-yield and emerging-market issuers, some of which are in “dirty” industries and are transitioning to more climate-friendly processes.

Sustainability-linked bonds are based on a KPI at firm level. If the company fails to achieve the KPI within the specified timeline, it is penalized with a coupon step-up on the bond. Accordingly, investors must research the company’s overall sustainability strategy and determine whether the KPI aligns with that goal.

For sustainability-linked bonds, there is a direct and enforceable monetary incentive for the issuer to perform, rather than reputational risk only. This type of structure makes the issuing company accountable for executing on a top-down strategy that materially changes the sustainability of the business, as opposed to simply identifying and segregating a set of green assets while continuing with business as usual for its other activities.

That’s why we like certain sustainability-linked structures. We think, for instance, that greenhouse gas KPIs that are aligned with the 2 Degrees Investing Initiative are well suited for high-emitting sectors such as energy, cement and some chemicals manufacturers.

One possible reservation about sustainability-linked structures is that investors benefit from the coupon step-up if the issuer fails to hit its target. While some see this as a misalignment of incentives, we view it like step-ups that result from a credit downgrade—we don’t want the downgrade to happen but expect to be compensated if it does. In the future, sustainability-linked structures may be developed with different issuer incentives that further improve alignment with investors’ objectives.

That said, sustainability-linked structures need to be monitored for greenwashing, given the inherent flexibility around use of proceeds. KPIs must be chosen and calibrated carefully. And investors should actively engage with the issuer to get progress updates on achieving the KPI and to better understand the tools used to meet it.

Due Diligence Still Key in Evolving ESG-Labeled Bond Market

While investors now have a wide range of ESG-labeled bonds to select from, they need to conduct thorough due diligence—to analyze the specifics of each bond’s structure and to understand how it supports the overall sustainability strategy of the issuing company. Identifying the right choice will also depend on the investor’s particular investments and ESG approaches.

But investors can be confident that the market is continuing to evolve to supply more choices and better accountability.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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AllianceBernstein (AB) is a leading global investment management firm that offers high-quality research and diversified investment services to institutional investors, individuals, and private wealth clients in major world markets. We believe corporate responsibility, responsible investing and stewardship are intertwined. To be effective stewards of our clients’ assets, we strive to invest responsibly—assessing, engaging on and integrating material issues, including environmental, social and governance (ESG), and climate change considerations in most of our actively managed strategies. We also believe that strive to hold ourselves as a firm to similar practices that we ask of issues. Our stewardship practices, investment strategy and decision-making are guided by our purpose, mission and values.

Our purpose—pursue insight that unlocks opportunity—inspires our firm to act responsibly. While opportunity means something different to each of our stakeholders; it always means considering the unique goals of each stakeholder. AB’s mission is to help our clients define and achieve their investment goals, explicitly stating what we do to unlock opportunity for our clients. We became a signatory to the Principles for Responsible Investment (PRI) in 2011. This began our journey to formalize our commitment to identify responsible ways to unlock opportunities for our clients through integrating material ESG factors throughout most of our actively managed equity and fixed-income client accounts, funds and strategies. AB also engages issuers where it believes the engagement is in the best financial interest of its clients.

Because we are an active manager, our differentiated insights drive our ability to deliver alpha and design innovative investment solutions. ESG and climate issues are important elements in forming insights and in presenting potential risks and opportunities that can have an effect on the performance of the companies and issuers that we invest in and the portfolios that we build.

Our values provide a framework for the behaviors and actions that deliver on our purpose and mission. Values align our actions. Each value emerges from the firm’s collective character—yet is also aspirational.

  • Invest in One Another means that we have a strong organizational culture where diversity is celebrated and mentorship is critical to our success. When we invest in one another, we empower our employees to reach their potential, so that they can help our clients realize theirs. This enables us to partner with clients to design and deliver improved investment outcomes.
  • Strive for Distinctive Knowledge means that we collaboratively identify creative solutions to clients’ economic, ESG and climate- related investment challenges through our expertise in a wide range of investment disciplines, close collaboration among our investment experts and creative solutions.
  • Speak with Courage and Conviction informs how we engage our AB colleagues and issuers. We seek to learn from other parts of our business to strengthen our own views. And we engage issuers for insight and action by sharing ideas and best practices.
  • Act with Integrity—Always is the bedrock of our relationships and has specific meaning for our business. Unlike many other asset managers, we’re singularly focused on providing asset management and research to our clients. We don’t engage in activities that could be distracting, or create conflicts—such as investment banking, insurance writing, commercial banking or proprietary trading for our own account. We are unconflicted and fully accountable.

As of September 30, 2023, AB had $669B in assets under management, $458B of which were ESG-integrated. Additional information about AB may be found on our website,

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