By Alan Meng, Sustainable Fixed Income Lead, Sustainable Investment Research, and Lee Clements, Head of Applied Sustainable Investment Research, Global Investment Research
Proceeds raised by green bonds are usually earmarked to finance climate change mitigation and adaptation projects, which has made them odds-on favourite for fixed income investors looking to decarbonise their portfolios. However, the boom of the market has also invited scepticisms over green credentials of some bonds and issuers. Recently, a slow-down in new issuances, anecdotal evidence about a narrowing ‘greenium’ spread, as well as a spike in green bond default rates, have raised tricky questions for investors. What does the market hold for green bonds when tailwinds turn to headwinds?
Soaring borrowing cost will continue to impact new issuances in the next few months
After six straight quarters with global issuance surpassing USD 120 billion, new green bond offerings dropped to around USD 95 billion in Q3 and Q4 2022 (Exhibit 1). The slump was primarily driven by Europe and North America, reflecting broader bond market weakness linked to soaring rates and geopolitical tensions (a broader analysis on the impact of rising rates on sustainable fixed income can be found here). High yield green bonds were particularly affected, in line with conventional high yield bonds that were seeing some of the lowest issuance levels since the Global Financial Crisis.
On the bright side, the proportion of new green bond offerings among overall bond sales remained robust at around 5% – significantly higher than the pre-pandemic period (Exhibit 1). It is also worth noting that green bonds, together with the pandemic-driven surge in social and sustainability bonds, have now accounted for over 12% of overall new bond issuance for eight consecutive quarters.
However, whilst high interest rates and market uncertainty continue to creating challenging conditions for new green bond borrowings, the beginning of 2023 has seen some positive momentum. In fact, the market saw its strongest January issuance since inception, primarily fuelled by sovereign and sub-sovereign issuers. If macro conditions continue to improve, combined with the widening supply – demand gap in the green bond market, rebound in new offerings could be faster than expected.
High quality green bond offerings continue to attract a ‘greenium’
Multiple studies have shown that the premium (or ‘greenium’) which investors are willing to pay for green bonds is shrinking, with green issuances seeing less pricing benefits in the primary market and yield spreads between green bonds and their vanilla benchmark narrowing in the secondary market.
Essentially, ‘greenium’ reflects the dynamics of supply and demand. Due to a combination of the buy-and-hold strategy of many green bond investors, moderating new issuance, and investors with green mandates looking to replace more than half trillion green bonds reaching maturity in the next three years (Exhibit 2), demand could put increasing pressure on limited supply. The uptick in total net assets of dedicated sustainable bond funds in Q4 last year (Exhibit 3) may be a leading sign of the continued upward pressure on pricing. But as ESG investors are becoming more sophisticated and discerning, only deals with strong green credentials from high-quality issuers will enjoy material pricing benefits.
Rising default rate is putting green bonds to the test
Green bonds have been considered as a tool for investors hedge against climate risks and achieve impacts in the long run. However, there has been a noticeable increase in defaults with 39 green bonds from 20 different issuers having defaulted as of the end of 2022 (Exhibit 4).
In one example, a USD 200 million green bond that was 14 times oversubscribed at issuance, failed to pay interests to investors with the price plunging to below 20 cents on the dollar. These defaults not only result in financial losses, but also raises questions about the issuers’ ability to fulfil their green commitments. While a green bond default does not necessarily mean that the underlying green projects has failed, none of these issuers have reported on the green bond proceeds allocation since their defaults, suggesting a lack of transparency and accountability in the utilisation of green bond proceeds and measurement of impacts.
The defaults are highly concentrated in China’s real estate sector, with 30 out of the 39 defaulted green bonds issued by mainland China or Hong Kong-domiciled real estate companies, reflecting broader credit constraints and slower growth in China’s real estate industry (the remaining green bond defaults occurred among renewable energy issuers in different parts of the world).
The overall green bond default rate, however, remains significantly below the average default rate in the broader bond market, at just 0.6% by number of deals over the past 15 years (or 0.45% by amount outstanding) These defaults serve as a reminder that, despite the growing excitement surrounding green commitments, creditworthiness should not be overlooked.
Challenges and uncertainty in the green bond market may persist, but the underlying growth dynamics for this asset class remain intact. This includes continued regulatory and policy support, with examples including the ECB’s recent bond portfolio decarbonization plan (where green bonds may be favourably treated in the primary market bidding) and Chinese central bank’s medium-term lending facility (in which green bond collaterals are given a preferential status). Combined with the growing demand from investors for green investment opportunities and issuers’ expanding needs for financing and refinancing green and transition plans, headwinds are likely to turn back to tailwinds eventually.
 Municipals, collateralised and structured products are not in the scope of this research.
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