Green, social or sustainable bonds (ESG bonds) have become an increasingly popular way for fixed income investors to signal that they are taking ESG seriously. But how do ESG bonds compare to traditional bonds? Is there a “greenium” (i.e., a higher price paid) to invest in this way and, if so, how can investors avoid paying it?

What are ESG bonds?

While there is no standard definition for what constitutes an ESG bond, it’s widely accepted that ESG bond issuers use the instruments to raise proceeds to fund sustainable projects, whether these are environmental or social in nature.

Typically, a corporation’s ESG bond issuance is backed by its balance sheet and therefore carries the same rating and credit risk as that entity’s traditional debt.

As noted, use of the ESG bond designation is not standardized, producing a wide variety of interpretations by issuers. A recent green bond issue by a high-yield industrial company offers an example of the need for careful analysis on the robustness of the designation beyond the label. This particular bond:

• Did not require a subaccount of proceeds for green uses, thus making it explicit that proceeds would be held in a commingled corporate account.
• Did not identify specific green projects that the proceeds would fund, instead listing generic ongoing projects that proceeds could be used to support.
• Did not identify explicit ESG/green goals or thresholds for the issuer to meet.
• Did not offer a coupon step to investors if the proceeds weren’t used for green projects or ESG targets weren’t met.
• Did not create a default scenario if proceeds were not used for green projects, thus creating no recourse for bond holders, once bonds were issued.

At issue, we estimated the approximate premium (i.e., higher cost) for investing in this “green” bond, relative to a traditional bond from that issuer, was about 25 basis points (bps). 

Comparing ESG bonds and traditional bonds

To evaluate how “ESG” an investment is, it must be possible to isolate the influence of ESG factors while effectively holding constant all other influencing factors.

This is difficult to achieve in the stock market because no two companies are identical. Isolating stock price differences attributable exclusively to ESG factors and comparing relative valuations on this limited basis are very difficult.

It’s different in the bond market. Here we can more readily assess the differences in valuations between traditional and ESG bonds if we compare bonds within a single issuer’s capital structure. It’s easier to isolate the influence of ESG factors while effectively holding constant all other factors that influence bond pricing. This allows us to assess if there is an average spread discount (lower compensation) on ESG bonds versus traditional bonds for companies that issue in both markets, and to quantify that spread concession.

Process: How we assessed spread differences between ESG and traditional bonds

Capital Group’s global Quantitative Research Analysis (QRA) group built a model to assess differences in valuations between ESG and traditional bonds for issuers active in both markets, across corporate and government entities.

To assess the impact of the ESG designation, the QRA group began by estimating the fair value for all green, social and sustain- able bonds outstanding as of November 2020 and May 2021. They did this by determining the valuation of adjacent traditional bonds on the issuer’s yield curve. Only bonds with the same currency, seniority, collateral and rating, with durations within one year of the ESG bond, were used to assess fair value. In many cases, sufficiently comparable bonds did not exist, and therefore the number of designated bonds under study was reduced to 843 and 1,175 for the November 2020 and May 2021 samples, respectively.

For the remaining sample, average yield spread and duration of the adjacent bonds was calculated and a fair value spread – agnostic of the ESG designation – was linearly interpolated for the ESG bond, given its duration. We did not adjust for possible differences in liquidity of ESG bonds versus the non-ESG bonds control group.

Isolating valuation differentials exclusively to the ESG designation in this way allowed us to conclude that the difference between the observed market spread on the ESG bond and the linearly interpolated fair value spread is the estimated cheapness (if positive) or richness (if negative) of the ESG bonds relative to their non-ESG bond counterparts.

After removing the extreme top and bottom two percentiles of the universe, the final November 2020 and May 2021 samples amounted to 809 and 1,128 bonds, respectively.

Results: There is a spread concession for ESG bonds

Our analysis found that investors may be paid less, in terms of spread, to invest in ESG-designated bonds. Overall, as seen in the figure below, we estimated that, on average, spreads of bonds with an ESG designation are 4.1 basis points and 3.1 basis points tighter relative to their adjacent non-ESG bonds, in the November 2020 and May 2021 samples, respectively. These differences are statistically highly significant.

We also found regional differences in this spread differential. As seen in the next chart, in the November 2020 sample euro (EUR)-denominated securities exhibit a 9 bps richer valuation for ESG- designated bonds, while non-EUR denominated securities exhibit only a 2 bps richer valuation. Similarly, in the May 2021 sample, the corresponding figures are 8.7 bps versus 0.8 bps.

The presence of the spread differential indicates that, in pure return terms, fixed income investors can be disadvantaged by investing in ESG bonds.

Our analysis as to the estimated spread discount investors accrue in buying ESG bonds was point-in- time and will be continually monitored, as this market likely continues to grow.

For the ESG bond investor, key investor questions should include:

• Has the company identified a specific use of proceeds, or will proceeds go towards “general corporate purposes?”
• Will proceeds be escrowed for green projects?
• Is there third-party auditing around the use of proceeds and “greenness” of the project, and are there explicit measurement goals the company must meet? What are the report requirements?
• What recourse do bondholders have if proceeds aren’t used for green projects or green goals aren’t met — e.g., coupon steps, event of default?

Investors in green bonds also must understand whether there is a spread discount from investing in a green issue, relative to a traditional bond from the same company, and if so, what is the magnitude of that concession.

Tara Torrens is a Fixed Income Portfolio Manager and Omer Brav is a Quantitative Analyst at Capital Group.