Sustainable investing is no longer the exclusive domain of equity investors. Indeed, there is a growing consensus that sustainability can be just as critical to investment outcomes in fixed income markets. Although environmental, social, and governance (ESG) integration and adoption have historically been slower in fixed income as compared to equities, investor demand for “green bonds” and other sustainable fixed income solutions has risen rapidly in recent years, particularly since the onset of COVID-19. Accordingly, the pace of new product innovation and proliferation has picked up as well.
Case in point: The booming global market for green/sustainability bonds has now expanded to convertibles — hybrid bonds that can be converted from debt into equity. While European debt issuers have thus far comprised most of the volume in these green, sustainability-linked, and/or social bonds, US and Asian issuers have become increasingly active in the space. The recent uptick of issuers selling green/sustainability convertible bonds includes companies focused on US renewable energy (solar panels and hydrogen cells) and Asian real estate developers (clean energy development and low-carbon emission buildings). We expect the trend to accelerate as investor demand for green/sustainability-labeled paper swells and as many borrowers realize the advantages of such issuance.
Green/sustainability-linked converts: A “win, win”
As the name suggests, the fundamental determinant of a green convertible bond is the utilization of the proceeds for green projects. By contrast, sustainability-linked convertibles do not have such green uses, but are linked to predefined sets of ESG targets. The advent and growth of green/sustainability-linked convertible bonds can be a “win, win” for the companies issuing the debt and the investors who purchase it, potentially helping both parties in the pursuit of their green/ESG objectives.
From the company’s perspective, issuing these bonds can provide reputational benefits (the so-called “halo effect”) and demonstrate the company’s commitment to achieving its sustainable goals. In addition, issuing green/sustainability-labeled convertible bonds may also deliver financial benefits to borrowers in the form of more favorable deal terms, such as lower coupon rates and/or higher conversion premiums at new issue — similar to what’s already been observed in the investment-grade and high-yield debt arenas, where many issuers of green bonds have been able to command better deal terms.
From the investor’s standpoint, consistent with climate change and other ESG issues being multiyear (or even multidecade) phenomena by nature, green/sustainability-labeled convertible bonds may be especially attractive to sustainability-minded investors with a longer-term orientation and approach to investing. And given that demand for these bonds currently outstrips the available supply, they often trade at a “greenium” — that is, a premium to their non-green-labeled convertible counterparts. In fact, for most of 2021, green convertibles have traded with a tighter implied spread than the broader global convertibles market.
How we integrate a sustainable investing framework
Besides investing in sustainability/green-linked convertible bonds outright, we also embed a robust ESG/sustainable investing framework throughout our investment process, from bottom-up fundamental security research to overall portfolio construction and risk management. At Wellington, our experience as active managers, our expertise across asset classes, and our proprietary ESG research are the foundations of our convertible investment philosophy.
Every year, we hold over 15,000 company engagements to better understand ESG factors and to advise issuers on material risks and potential improvement paths. Our engagement policy is based on generally accepted best practices, such as the OECD Principles of Corporate Governance, the UN Global Compact, and the UK Stewardship Code. We use engagement as a platform to share our expectations with companies and to identify their ESG strengths and deficiencies, along with their approach to sustainability.
Recent engagement examples include:
- Environment/low-carbon transition: We engaged with a cruise line operator on establishing carbon reduction targets, improving exhaust gas cleaning systems, and utilizing liquefied natural gas (LNG)-powered ships.
- Social/human capital: We engaged with a US ride-hailing company on employee and passenger safety and security, as well as on driver and employee satisfaction metrics.
- Governance/shareholder rights, data privacy: We engaged with a US car manufacturer on ideas for scrapping its dual-class voting structure, establishing a cybersecurity committee, and publishing a lobbying and political contributions report.
Across the fixed income spectrum, we expect green/sustainability-linked bond issuance to continue to gain traction in response to healthy investor demand. We engage with convertible bond issuers when we see areas where we think they can improve, because when they perform better on the sustainability issues most relevant to financial outcomes, we believe our clients are likely to benefit.