In the earlier stages of the ESG-linked bond market, we saw issuers given a significant advantage when issuing a Green, Social or Sustainable bond compared to their conventional corporate bonds. Essentially, these ESG-labeled bonds are issued at higher prices than traditional bonds and have lower yields, simply because of the ESG label on the bond. This lower spread at issuance was attributed mainly to low supply and high demand as new ESG-dedicated fixed income funds competed for a finite, albeit growing, number of ESG-labeled instruments while also building their dedicated fund offerings.
In 2019 and 2020, an issuer could save 10 or more basis points (bps) in interest cost by issuing an ESG-labeled bond instead of conventional debt (a large discount on $500M to $1B in borrowing). This cost advantage became known as a "greenium." Some investors (including ourselves) were concerned about whether the size of the discount was warranted relative to how impactful the use of proceeds would be on actual ESG issues. Green and Social bonds often have long lookback periods, allowing issuers to finance past projects that were already part of the businesses' plans even before the advent of ESG-labeled debt. While we applauded the increasing focus on Environmental and Social projects, we questioned whether some issuers were simply funding business as usual activities but gaining a cost advantage simply through a label.
As the ESG bond market has grown, we have seen the "greenium" evaporate in many deals, thus eliminating the funding advantage borrowers have had in previous years, receiving favourable treatment by the markets with better pricing and lower rates. As highlighted below, we have seen US investment grade issuers go from a nearly 20 bps funding advantage in 2020 to an under 5 bps funding advantage this year. European ESG bond markets are more mature and actually posted zero cost savings in 2022, a far cry from the over 10 bps advantage seen in 2019.
The diminishing "greenium" is a welcome trend in our view! We believe this trend represents the maturing nature of the ESG labeled bond market, where issuers only gain a cost advantage on the ambition of their ESG bond issuance rather than the label. We believe this is a key development in ensuring the longevity and credibility of ESG bond markets, allowing managers to express views on issuers either through conventional or ESG debt without causing large pricing discrepancies. This can also be a case for Sustainability Linked Bonds (SLBs), which incentivize improvements in a company's ESG profile, bringing the focus back to ambition over labeling.
The structuring of ESG bonds is also maturing thanks to ongoing feedback and collaboration from investors. Issuers are now actively addressing "greenwashing" claims by embedding incrementality into their ESG bond issuance. This ensures that proceeds are used to fund new projects/activities rather than financing "business-as-usual" operations. For example, to avoid the lookback periods mentioned above, we have seen new issues from the likes of Bank of America and Honda whose use of proceeds will be 100% dedicated to new projects rather than financing preexisting projects.
As the ESG debt market matures, we look forward to increasing credibility within the marketplace where issuers utilize these structures to target true impact. Only then can the dialogue move from "greenwashing-or-not" to "how can we allocate investment dollars to the most impactful ESG bonds."