Bond Impact – Filling the Funding Gap

    Green bonds, the best known of all impact financial instruments, are going mainstream. Earlier this year, the green bond market passed another major milestone, topping EUR 1 trillion of outstanding green bonds. Meanwhile, the issuance is expected to jump 25% to around EUR 500 billion or even higher in 2022. This is a welcome development for NN Investment Partners (NN IP), a frontrunner in green bond investing. Douglas Farquhar, Senior Client Portfolio Manager at the firm, tells us more about the rapidly growing market and the way NN IP is helping investors greenify their fixed income allocation.

    Green Tailwinds

    According to Farquhar, several key factors support the issuance of green bonds, not just this year but also further down the road. There is, to start with, a catchup effect. A lot of green bond issuance was postponed in 2020 due to the Covid-19 pandemic that disrupted the bond markets. Then there are the debutants to the green bonds ball. This year has witnessed first-time sovereign green bond issuance from governments like Italy, Spain, and the UK.

    Douglas Farquhar, Senior Client Portfolio Manager at NN Investment Partners

    Perhaps of paramount importance, however, is the start of the EU green bond issuance. Planned to total EUR 250 billion, it is the main way to finance the ‘Next Generation EU’ recovery program. “The new issuance next year could well exceed our expectations, depending on how fast the EU looks to issue more green bonds after the debut on Oct. 12, when it sold EUR 12 billion worth of green bonds,” comments Farquhar.

    Apart from financing the recovery plan, other developments within the EU provide solid tailwinds for green bonds, too. Corporate issuance is picking up supported by the introduction of the EU Taxonomy. Although far from complete, the new framework defines clear green criteria for several sectors. Farquhar sounds positive overall to the work of the regulators so far, especially the ‘Do No Significant Harm’ rules, yet slightly concerned by the lack of synchronisation between EU’s Green Taxonomy and the new Green Bonds standards.

    Beyond Green Bonds

    Speaking of the EU Taxonomy, Farquhar comments on the recent proposals to extend the regulatory framework to other sustainability aspects. “It is a struggle for the EU regulators to define what is ‘green’, but you could say it is easy, compared to defining what is socially sustainable,” he says. “It adds a whole new dimension of complexity to find common standards for the social aspect,” he adds.

    Social and sustainable bonds, too, have a long way to go, according to Farquhar, before they reach the level of standardisation and the acceptance that green bonds enjoy today. “Recent years have seen a ‘label-mania’ in the market with a stream of new impact bond labels appearing,” he says. Social bonds, in particular, have increased dramatically during the Covid-19 pandemic, with governments and supranational institutions issuing to fund the recovery and support people through the crisis. Sustainability bonds, too, have proven popular for issuers who wish to finance a mix of environmental and social projects.

    “Transition bonds, however, seem to have suffered from the emergence of sustainability-linked bonds (SLBs),” comments Farquhar. “Investors are yet to be convinced of the need for a transition label when green bonds are a transition mechanism with clearly defined standards,” he adds.

    Farquhar urges caution with respect to sustainability-linked bonds. “The issuers set their own key performance indicators (KPIs) and targets linked with debt, and it is important to verify that these are truly the most material ESG metrics,” he points out. “Improving the habitat of urban pigeons, for instance, might not be the most relevant target to base an SLB on,” he jokes. On a more serious note, he thinks investors should be mindful of how SLBs are structured and make sure that the level of investor compensation is appropriate, with a clearly defined coupon step-up if issuers fail to meet their self-imposed targets.

    Investing In Green Bonds, the NN IP Way

    Back to classic green bonds, Farquhar takes us through the unique and sophisticated investment process that NN IP has developed throughout years of investing in these distinct fixed income instruments. “Since we first became active in the green bond market in 2014, we have been firm in our conviction that allocating to green bonds enables investors to make an environmental impact without sacrificing liquidity and returns. Over the years, we have developed and fine-tuned our approach as the market has grown and become more sophisticated, but our conviction remains unchanged,” he says.

    “Our dedicated green bond team of portfolio managers and analysts is part of our global investment-grade credit department, and its investment process is fully aligned with our regular credit process,” explains Farquhar. “Our Responsible Investing team also approves every green bond before it is eligible for investment,” he adds. As a result of this stringent selection process, NN IP rejects about 20% of the total outstanding issues in the official global green bond universe.

    He seems genuinely proud of the experience and professionalism of his colleagues at NN IP. “Our in-house green bond analysis is supported by a proprietary assessment methodology and database, giving us a comprehensive overview of the market and its constituents,” he says. The NN IP approach to creating and reporting on impact has gained recognition, with several responsible investing labels and awards from independent agencies, such as MSCI AA, 4 Morningstar globes, Scope AA+, Towards Sustainability (Belgium) and Greenfin (France).

    On Engaging, and Avoiding Greenwashing

    State-of-the-art database aside, investing in green bonds is not just about pouring over data and comparing spreadsheets. At NN IP, entering and maintaining an active dialogue with issuers is an integral part of the overall assessment of an entity, whether corporate, government or supranational, and its bonds. “We start the conversation prior to a bond’s issuance and focus on building up a mutually beneficial relationship with the issuer,” explains Farquhar. “They offer us insights on their business and strategy; we can inform them on best practice and what investors are looking for.”

    “We maintain a dialogue with most of the issuers in whose bonds we are invested and for the bonds that we have labelled as green and non-green in our database,” continues Farquhar. “We engage with non-green issuers too, as we want to help them improve their green bond frameworks and meet our strict standards,” he adds.

    The issuers’ voluntary commitment to report on their contribution to climate change and the self-labelled nature of green bonds imply that greenwashing is a significant risk for investors who want to make a clear positive impact and avoid reputational damage. “Engagement is an important tool in mitigating this risk,” says Farquhar. “Regular contact gives us a better understanding of both the issuer and the individual bond issue and helps ensure we do not invest in entities that are not as ‘green’ as they might first appear to be,” he says.

    One example Farquhar mentions is downgrading the bonds issued by the State Bank of India to non-green. The bank was issuing green bonds while preparing a loan to Adani for investment in the Carmichael mine in Queensland, Australia. Furthermore, the issuer was reluctant to engage in a constructive dialogue with NN IP. This was sufficient to motivate the downgrade making the bonds ineligible for the asset manager’s green bond portfolios.

    “When it comes to greenwashing, it is key to assess all the activities of the issuer itself, particularly within the financials and utilities sectors,” says Farquhar. He is critical of banks that try issuing green bonds while continuing to lend money to fossil fuel projects. Sovereigns can be challenging, too. He mentions, for instance, that it is difficult to accept Poland’s sovereign bond in the green family, given the country’s continued dependence on coal.

    The Future Is Green

    Rounding up the interview, Farquhar peeks into the future of green bonds. “There is no doubt that the market is growing,” he says. “The question is whether it is growing fast enough. The funding gap to finance the transition to a greener economy is still enormous,” he adds.

    The positive news is that with the US rejoining the Paris Agreement and the EU’s commitment to a green recovery, we can expect a wave of new climate regulations and incentives, which will have a massive impact on the investing landscape, according to him.

    “Green bonds have become a mainstream fixed income segment that every bond investor should consider when constructing their portfolio,” he urges. “In addition to their transparent use-of-proceeds structure and focus on climate change mitigation and adaptation, these liquid, diversified investments offer similar attributes to traditional bonds and an appealing risk-return profile,” he points out.

    “NN IP is a dark green investor. Making a positive and demonstrable environmental impact is our key goal. Yet we also aim to deliver a positive financial return to our clients,” concludes Farquhar.


    Image courtesy of Nick Grappone on Unsplash
    Julia Axelsson, CAIA
    Julia Axelsson, CAIA
    Julia has accumulated experience in asset management for more than 20 years in Stockholm and Beijing, in portfolio management, asset allocation, fund selection and risk management. In December 2020, she completed a program in Sustainability Studies at the University of Linköping. Julia speaks Mandarin, Bulgarian, Hindi, Russian, Swedish, Urdu and English. She holds a Master in Indology from Sofia University and has completed studies in Economics at both Stockholm University and Stockholm School of Economics.

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