Financial Planning
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A sustainable investment approach may screen securities or sectors based on pre-defined environmental, social, and governance (ESG) criteria, or it may consider ESG factors alongside more traditional financial analysis. ESG-oriented strategies such as these can be applied to the selection of bonds as well as stocks in portfolio construction and management.
Sustainable bonds (or impact bonds) are debt instruments that were designed to fund the transition to a low carbon economy and help government entities and businesses meet internationally recognized ESG goals, such as those outlined in the Paris Agreement or the United Nations Sustainable Development Goals. The first bond with a "green" label was issued by the World Bank for institutional investors in 2008.1 In 2023, global issuance of green, social, sustainability, and sustainability-linked (GSSS) bonds approached $1 trillion and accounted for about 13% of the total bond market.2
This burgeoning sector of the bond market offers a wide range of opportunities for fixed income investors to pursue financial returns and help change the world at the same time. If the inner workings of sustainable finance are new to you, an overview of the labels used to distinguish one bond type from another might be a good place to start.
Green bonds are the largest category of sustainable bonds. The proceeds can be used exclusively to finance new or existing projects or activities that aim to have a positive impact on the environment. Some examples include renewable energy production, energy efficiency improvements, electric grid modernization, natural resources conservation, clean transportation systems, and climate change adaptation. (Blue bonds, which are a small subset of green bonds, are specifically earmarked for projects oriented toward protecting the oceans, including marine ecosystems and maritime resources.)
The proceeds of social bonds are generally used to finance (or refinance) projects that are intended to help solve social issues, alleviate human suffering, and/or address inequality. Some examples include poverty reduction, employment creation, food security, affordable housing, and access to health care, education, and clean water.
The proceeds of sustainability bonds might be used to fund a combination of both green and social initiatives.
Bonds that fit into any of these three classes (green, social, and sustainability) are referred to as "use of proceeds" bonds because the funds are intended for specific purposes.
With sustainability-linked bonds, issuers that have committed to pre-set sustainability targets can use the proceeds for general purposes. The financial or structural characteristics of these bonds may vary depending on the achievement of key performance indicators, such as reductions in greenhouse gas emissions.
Transition bonds can be either sustainability-linked or use-of-proceeds bonds issued specifically to support climate transition goals, particularly in hard-to-abate sectors for which low carbon technologies are not yet available at scale (such as cement, steel, and chemicals). The projects financed may not always be "green" as typically defined, but the funds may help borrowers implement changes that lessen their negative impact.
Sustainable bonds are issued by sovereign nations, government agencies, development banks, regional and local governments, municipalities (in the United States), and corporations.
In recent years, the European Union (EU) and dozens of advanced and developing nations have issued sustainable bonds. The U.S. government has not sold sovereign sustainable bonds, but government-sponsored mortgage giant Fannie Mae, some states and municipalities, and numerous U.S. corporations have issued them.
Like all bonds, sustainable bonds are rated for credit risk — the risk that the borrower will fail to repay the loan. A range of AAA down to BBB- (or Baa3) is considered "investment grade." Lower-rated or "junk" bonds tend to offer higher yields, but they also carry greater risk. Because governments have the power to raise taxes and fees as needed to pay the interest, sovereigns and municipals are generally considered to be less risky than corporates.
Bond prices and interest rates are also influenced by supply and demand. In some cases, enthusiastic investor demand for green bonds has driven up prices and pushed down yields, resulting in a small cost savings for the issuers and suggesting that the buyers were willing to pay a slight premium (or "greenium") for bonds that will be used to help fund a sustainable future.3
Bond issuers typically provide investors with detailed project plans, estimates of the environmental impacts, and regular progress reports. But so far, regulatory oversight of the sector has been weak. The term "greenwashing" reflects concerns that some issuers may try to attract eco-conscious investors with misleading claims.
Although there are no universally recognized standards for "green" bonds, issuers often align their bonds with one of two sets of voluntary market standards, each with its own environmental criteria tailored towards reducing greenhouse gas emissions and addressing climate-related challenges. The Green Bond Principles of the International Capital Markets Association (ICMA) is the most prevalent set of guidelines, partly because the Climate Bond Standard (from the Climate Bond Initiative) has more specific and stringent criteria and requirements. The ICMA's Social Bond Principles outlines best practices for issuing social bonds. Issuers may enlist third-party accounting or ESG rating firms to review and verify that their sustainable bonds align with a particular standard. To obtain certification, issuers must disclose the risks, environmental benefits, and financial characteristics of their projects.
The EU has created a new voluntary standard for use of the "European green bond" or "EuGB" label by issuers that follow transparency, reporting, and external review requirements that align with the existing EU taxonomy, which specifically defines which economic activities are considered environmentally sustainable (effective in late 2024). More government regulation is likely to come into play, and eventually some of today's voluntary practices could become mandatory.
Regardless of how a bond is labeled, investors may want to take a deeper dive into the specific projects being funded, as well as the issuer's financial strength and overall ESG track record.
1) The World Bank, 2021
2) S&P Global Ratings, February 13, 2024
3) Climate Bonds Initiative, 2024
The principal value of all bonds tends to fluctuate with changes in market conditions. As interest rates rise, bond prices typically fall, and vice versa. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk. In addition to credit and interest-rate risks, the risks associated with purchasing bonds from other countries include differences in financial reporting, currency exchange risk, as well as economic and political risks unique to a specific country. This may result in greater price volatility.
Interest paid by municipal bonds issued by the owner's state or local government is typically free of federal income tax. If a bond was issued by a municipality outside the home state, the interest could be subject to state and local income taxes. A municipal bond sold at a profit could incur capital gains taxes. Some municipal bond interest could be subject to the [federal and state] alternative minimum tax.
There is no assurance that employing ESG strategies will result in more favorable investment performance.
ESG Debt: Scoping Out the Universe of Sustainable Bonds
Sustainable bonds (or impact bonds) are debt instruments that were designed to fund the transition to a low carbon economy and help government entities and businesses meet internationally recognized ESG goals, such as those outlined in the Paris Agreement or the United Nations Sustainable Development Goals. The first bond with a "green" label was issued by the World Bank for institutional investors in 2008.1 In 2023, global issuance of green, social, sustainability, and sustainability-linked (GSSS) bonds approached $1 trillion and accounted for about 13% of the total bond market.2
This burgeoning sector of the bond market offers a wide range of opportunities for fixed income investors to pursue financial returns and help change the world at the same time. If the inner workings of sustainable finance are new to you, an overview of the labels used to distinguish one bond type from another might be a good place to start.
Green bonds
Green bonds are the largest category of sustainable bonds. The proceeds can be used exclusively to finance new or existing projects or activities that aim to have a positive impact on the environment. Some examples include renewable energy production, energy efficiency improvements, electric grid modernization, natural resources conservation, clean transportation systems, and climate change adaptation. (Blue bonds, which are a small subset of green bonds, are specifically earmarked for projects oriented toward protecting the oceans, including marine ecosystems and maritime resources.)
Social bonds
The proceeds of social bonds are generally used to finance (or refinance) projects that are intended to help solve social issues, alleviate human suffering, and/or address inequality. Some examples include poverty reduction, employment creation, food security, affordable housing, and access to health care, education, and clean water.
Sustainability bonds
The proceeds of sustainability bonds might be used to fund a combination of both green and social initiatives.
Bonds that fit into any of these three classes (green, social, and sustainability) are referred to as "use of proceeds" bonds because the funds are intended for specific purposes.
Sustainability-linked bonds
With sustainability-linked bonds, issuers that have committed to pre-set sustainability targets can use the proceeds for general purposes. The financial or structural characteristics of these bonds may vary depending on the achievement of key performance indicators, such as reductions in greenhouse gas emissions.
Transition bonds
Transition bonds can be either sustainability-linked or use-of-proceeds bonds issued specifically to support climate transition goals, particularly in hard-to-abate sectors for which low carbon technologies are not yet available at scale (such as cement, steel, and chemicals). The projects financed may not always be "green" as typically defined, but the funds may help borrowers implement changes that lessen their negative impact.
Global sustainable bond issuance, by type
Looking beyond the label
Sustainable bonds are issued by sovereign nations, government agencies, development banks, regional and local governments, municipalities (in the United States), and corporations.
In recent years, the European Union (EU) and dozens of advanced and developing nations have issued sustainable bonds. The U.S. government has not sold sovereign sustainable bonds, but government-sponsored mortgage giant Fannie Mae, some states and municipalities, and numerous U.S. corporations have issued them.
Like all bonds, sustainable bonds are rated for credit risk — the risk that the borrower will fail to repay the loan. A range of AAA down to BBB- (or Baa3) is considered "investment grade." Lower-rated or "junk" bonds tend to offer higher yields, but they also carry greater risk. Because governments have the power to raise taxes and fees as needed to pay the interest, sovereigns and municipals are generally considered to be less risky than corporates.
Bond prices and interest rates are also influenced by supply and demand. In some cases, enthusiastic investor demand for green bonds has driven up prices and pushed down yields, resulting in a small cost savings for the issuers and suggesting that the buyers were willing to pay a slight premium (or "greenium") for bonds that will be used to help fund a sustainable future.3
Bond issuers typically provide investors with detailed project plans, estimates of the environmental impacts, and regular progress reports. But so far, regulatory oversight of the sector has been weak. The term "greenwashing" reflects concerns that some issuers may try to attract eco-conscious investors with misleading claims.
Although there are no universally recognized standards for "green" bonds, issuers often align their bonds with one of two sets of voluntary market standards, each with its own environmental criteria tailored towards reducing greenhouse gas emissions and addressing climate-related challenges. The Green Bond Principles of the International Capital Markets Association (ICMA) is the most prevalent set of guidelines, partly because the Climate Bond Standard (from the Climate Bond Initiative) has more specific and stringent criteria and requirements. The ICMA's Social Bond Principles outlines best practices for issuing social bonds. Issuers may enlist third-party accounting or ESG rating firms to review and verify that their sustainable bonds align with a particular standard. To obtain certification, issuers must disclose the risks, environmental benefits, and financial characteristics of their projects.
The EU has created a new voluntary standard for use of the "European green bond" or "EuGB" label by issuers that follow transparency, reporting, and external review requirements that align with the existing EU taxonomy, which specifically defines which economic activities are considered environmentally sustainable (effective in late 2024). More government regulation is likely to come into play, and eventually some of today's voluntary practices could become mandatory.
Regardless of how a bond is labeled, investors may want to take a deeper dive into the specific projects being funded, as well as the issuer's financial strength and overall ESG track record.
1) The World Bank, 2021
2) S&P Global Ratings, February 13, 2024
3) Climate Bonds Initiative, 2024
The principal value of all bonds tends to fluctuate with changes in market conditions. As interest rates rise, bond prices typically fall, and vice versa. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk. In addition to credit and interest-rate risks, the risks associated with purchasing bonds from other countries include differences in financial reporting, currency exchange risk, as well as economic and political risks unique to a specific country. This may result in greater price volatility.
Interest paid by municipal bonds issued by the owner's state or local government is typically free of federal income tax. If a bond was issued by a municipality outside the home state, the interest could be subject to state and local income taxes. A municipal bond sold at a profit could incur capital gains taxes. Some municipal bond interest could be subject to the [federal and state] alternative minimum tax.
There is no assurance that employing ESG strategies will result in more favorable investment performance.
