This decision tree poses questions at two levels:
Level 1: Is the borrower free of ESG controversy? Our top priority is to discover whether the issuer is saddled with ESG controversy. For example, a company with a history of polluting would struggle to convince the public that its ESG bonds were more than lip service. In fact, simply issuing an ESG-labeled bond holds a firm up to extra media scrutiny, where even a hint of hypocrisy can damage reputations overnight and hurt bond performance. Therefore, this threshold is intentionally onerous.
At this level, we also consider a company’s fundamental ESG scores in AB’s proprietary credit rating and risk-scoring platform, PRISM. In our view, if the issuer’s ESG score is low, whether on individual or combined environmental, social or governance criteria, it should not issue an ESG-labeled bond. For example, a company may have a reputation for furthering environmental causes, but other controversial activities will knock it out of the running for issuing ESG-labeled debt.
In addition to scrutinizing individual companies for potential headline-making controversy, our research points to some sectors being a mismatch for ESG-labeled bonds—specifically, those that generate meaningful revenues directly from tobacco, adult entertainment, alcohol, gaming, weapons and agriculture directly tied to deforestation, such as palm oil. Fossil fuel companies won’t be credible ESG-labeled bond issuers unless they also have a credible decarbonization plan.
Companies that can’t pass the Level 1 threshold should not issue ESG-labeled bonds, and if they do, investors should avoid them. On the other hand, issuers that pass our Level 1 threshold are suited to issuing ESG-labeled bonds, and so their ESG-labeled bonds proceed to the next level in our decision tree.
Level 2: Are the KPI targets for sustainability-linked bonds or the use of proceeds for project-based bonds acceptable, and are the bond’s mechanics appropriate? An ESG-labeled bond’s targets and use of proceeds must be appropriate for both the company and its industry. For green or social bonds, that means the proceeds must clearly align with green or social goals; for sustainability-linked bonds, the KPI target must be among the most relevant ESG metrics for the issuer’s industry and be sufficiently ambitious that its impact will be meaningful and lasting.
But that’s not all. At this level, we also consider whether the use of proceeds could cause material harm in other respects. For instance, a proposed hydroelectric dam financed through a green bond may create severe damage to the local environment and communities.
Next, are the bond’s mechanics appropriate? Answers here reveal the more tactical aspects of the ESG-labeled bond issue. Will the funds raised be deployed in a timely manner? Is the timeline for meeting the KPI reasonable? If a sustainability-linked bond misses its target, will the step-up penalty be consequential enough? And lastly, does the company plan to issue more ESG-labeled bonds down the road, contributing to a more robust ESG market?
Investors may want to minimize exposure to ESG-labeled bonds that don’t pass this level. However, if the bond checks some but not all “yes” boxes, investors should evaluate it like a conventional bond. Finally, if it resoundingly passes the threshold, we consider it a fairly structured ESG-labeled bond and evaluate it accordingly. That usually means being willing to accept a modestly lower yield, known as a greenium, in exchange for typically smaller drawdowns during periods of market stress, as discussed above.
This framework helps us rapidly vet noncontroversial, well-structured ESG-labeled bonds. But it also fosters open and clear communication among stakeholders, from investors to bankers to issuers. It helps issuers better understand why investors decide for or against buying their bonds and creates opportunity for them to revise the terms of new issues when it’s prudent. Moreover, by adhering to such a framework, investors can help raise the bar for ESG-labeled bond issuance and affect corporate behavior over time.
Less Greenwashing Can Mean More Alpha
Across global fixed-income markets, ESG-labeled bonds are priced somewhat higher—and thus offer modestly lower yields—than their conventional cohorts. According to our above framework, accepting this minor greenium can, counterintuitively, improve alpha. Currently, this greenium ranges between 1% and 5% of the average spread for the region and industry of issue (Display). Europe sees the smallest greeniums, as it has the biggest supply of ESG-labeled bonds.