The recent credit market selloff has been particularly hard on sustainable debt, challenging the popular premise that investors can do well and do good at the same time.
A Bloomberg index of environmental, social and governance debt has lagged a global bond benchmark by about 64 basis points over the past year. In Europe, which dominates the $4 trillion market, green corporate bonds have slumped 6.7% so far this year, more than the 6.1% loss for normal debt. China high-grade corporate green bonds underperformed non-green peers in the first quarter while in the U.S., green bonds modestly outperformed like-for-like counterparts, according to Morgan Stanley.
There’s more than one reason. ESG bonds started out more expensive, with demand outstripping supply in buzzy debuts from the European Union, Ford Motor Co. and others. With typically longer maturities, they’ve also been hit harder by the prospect of rising interest rates, contrary to the expectations that they’d hold up in volatile global markets.
“We don’t really have data that proves that over a full credit cycle, green bonds outperform because they are owned by longer-term investors,” said Stephen Liberatore, head of ESG and Impact for Global Fixed Income at Nuveen, which oversees $1.3 trillion globally. “At the moment what you have is simply people arguing that it should be that way.”
Sustainable assets should retain their appeal, the theory goes, because funds face investor and regulatory pressure to make their portfolios more sustainable in the long-term. But so far, that hasn’t been the case as rising rates, the risk of another economic slowdown and geopolitical tensions result in the worst losses in credit markets since the global financial crisis.
ESG securities are a relatively recent phenomenon and, given central banks’ support during the pandemic, they haven’t really gone through a proper down cycle, said Liberatore, who manages about $18 billion in sustainable assets, including green, social and sustainability bonds.
Increased regulatory scrutiny means investors now have to “enumerate and explain” how they’re implementing ESG strategies, he added. That, in turn, is a reaction to growing concerns over greenwashing. Even polluters such as airports and petrostates have rushed to issue sustainable notes as a way to lower borrowing costs.
“It’s going to become much more idiosyncratic,” said Liberatore. “You are going to have to do more of the work. It isn’t going to be as simple as, ‘I’m just going to buy a green bond and it’s going to outperform.”
Barclays Plc compared the performance of labeled bonds versus regular bonds at the height of the coronavirus pandemic and didn’t find a huge difference, the bank’s ESG credit strategist Charlotte Edwards said in an interview on Monday. The strong demand for new sales may also mask weaker interest in the secondary market, Edwards and her team wrote in a 2021 report. Long-term institutional investors -- pension funds, asset management arms of insurance companies and mutual funds, for example -- may be disappointed if and when they try to liquidate their holdings, the Barclays group wrote.
Instead of bonds labeled ESG, investors should seek out companies that offer products and services that are aligned with long-term trends toward sustainability, said James Rich, a senior portfolio manager at Aegon Asset Management. Those notes are cheaper relative to explicit ESG bonds, which makes them cheaper but no less sustainable, he said. Charlene Malik, portfolio manager at TwentyFour Asset Management, also prefers to look at a company’s ESG profile as opposed to individual bonds and she doesn’t expect labeled debt to outperform regular bonds, she said in an interview Wednesday.