Renewed economic growth and lower interest rates should support corporate bonds generally. Sustainable corporate bonds in particular may benefit from additional tailwinds and provide investors with opportunities to boost returns and temper credit risk, write Michel Baud and Yrieix De James.
The sustainable bond market – Large and expanding
The market for sustainable bonds has grown rapidly over the last decade to reach about 14% of the global fixed income market.1 This swift growth was supported by strong investor demand around the world.
Issuance has broadened from the more familiar ‘green’ bond structure to social bonds, sustainable bonds, and more recently into sustainability-linked structures (see Exhibit 1). This has added to the appeal of the asset class.
Global issuance of green, social, sustainability, sustainability-linked and transition (collectively, sustainable) bonds totalled USD 216 billion in the third quarter and USD 769 billion in the first nine months in 2024, according to November 2024 data from Moody’s.
The Moody’s expects total sustainable bond volumes to reach USD 950 billion for the full year, buoyed by ‘continued issuer appetite for funding environmental and social projects with ESG-labelled bonds.
Investors eager for more sustainable corporate bond exposure can find a wealth of choices across regions, sectors, and industries as companies are expected to account for about a half of the total USD 1 trillion of global sustainable bonds issued in 2024.2
Corporate issuance has tended to come from sectors such as utilities, banking and real estate investment trusts (REITs). Now, issuers from other sectors have come forward as the asset class has grown. We expect that trend to continue. Sustainability has steadily drawn interest from institutional and retail investors as governments have generally been setting more aggressive targets for public and private sector sustainability.
Today, sustainable corporate bonds are issued mainly by eurozone companies and denominated in EUR. Regional demand has risen hand in hand with expanding EU sustainability-driven regulation.
However, companies from Asia and the broader Europe, Middle East and Africa (EEMEA) region have become significant issuers, whether in EUR or USD. While there is issuance in developed market currencies such as GBP, EUR and USD bonds now make up the bulk of sustainable corporate bond issuance, at near 94% of the yearly total on average over the last 10 years, according to Bloomberg.
Intertwined – Prudent investment and sustainability
It used to be that when a company had well-articulated sustainability goals, there was an environmental ‘bonus’ for holding their bonds. Today, it is becoming clear that companies that cannot, or do not, formulate compelling sustainability goals risk being penalised by the market.
While our corporate bond investment process has focused on companies with robust fundamentals, a company’s commitment to sustainability is becoming a driving factor of those fundamentals. Whether it is at the sector, industry, or security level, companies not actively pursuing sustainability could — at best — fall behind competitors, which would add to their long-term credit risk.
For example, utilities that are still using coal to generate power have seen their cost of funding rise over the past few years as investors see growing risks to their business model and thus demand a higher risk premium. On the other hand, semiconductors, once seen as mostly cyclical components, are now viewed differently given their important role in decarbonisation and the green transition.
More broadly, financial markets are seeing the pivot towards greater sustainability as both necessary and expensive, requiring investment and thus investor capital. As the sustainable corporate bond market expands in breadth and depth, it provides opportunities for investors to choose the more sustainable option.
We expect more companies that are not pursing sustainability to see a deterioration in their credit quality, whether through higher borrowing costs or falling market share.
Sustainability – Benefits investors
History suggests that investors can generally expect to earn the same or similar return from sustainable corporate bonds as they do from conventional corporate bonds. In the eurozone, for example, the performance of the European corporate green bond index has closely tracked that of the European investment-grade (conventional) corporate bond index.3
Most investors gain exposure to sustainable corporate through actively managed bond funds. These funds can benefit from inefficiencies in traditional corporate bond benchmarks: the latter are market-cap weighted indices which may include bonds of large companies resisting sustainability. Since that curbs their appeal to sustainable investors, those investors would seek a higher reward for this risk.
Finally, the performance of sustainable bonds should benefit from positive ‘technicals’: we expect there to be a prolonged gap between supply and demand. While issuance had dropped off due to slower economic growth and higher interest rates, we now expect investor appetite for sustainable bonds to steadily increase in the years ahead. As such, sustainable bonds could exhibit lower volatility, particularly in times of market stress, as investors compete for limited supply.
A positive outlook for corporate bonds…
Global corporate bonds have done well in 2024. While uncertainties remain, we believe robust growth in the US, the prospect of faster global growth as policy rates fall, and steady demand for the higher yields of corporate bonds will support the asset class in 2025.
Historical data is somewhat mixed on how corporate bonds perform during a cycle of monetary easing, but our analysis suggests that in each instance where there was either no recession or only a mild one, corporate bonds did well relative to other asset classes.
Over the last few years, policy rates have risen significantly, particularly in the US. This leaves more room for them to fall now, supporting the outlook for companies, not just in America but across the developed world. Furthermore, any decline in global government bond yields should benefit the total return of corporate bonds even if their yield spread over government bonds remains stable.
In recent quarters, the performance of corporate bonds has been helped by steady demand. Investors quickly took up near-record issuance of investment-grade corporate bonds. In the US, demand has exceeded supply by 3.7 times so far this year.4
Looking ahead, we could see even more demand for corporate bonds as short-dated government bond yields fall in line with lower central bank rates and investors rotate from increasingly lower yielding money-market funds to higher-yielding corporate bond funds.
Political uncertainty remains a key risk, but we believe the combination of strong fundamentals, a favourable macroeconomic outlook, steady demand for the asset class, and elevated yields justify maintaining exposure to corporate bonds.
A more positive one for sustainable corporate bonds
We believe several factors could give sustainable bonds compelling advantages in the quarters ahead.
First, demands for a company to have clear sustainability goals is likely to be a tailwind for its credit quality relative to peers. Such goals could position the company for higher revenues in the longer term and a lower exposure to environmental risk. Further, some of the fastest-growing industries today are those squarely focused on sustainability, e.g., battery technology or renewable energy.
Second, in a monetary easing cycle, the sectors which typically benefit the most from lower interest rates are many of the same sectors changing or needing to change their approach to sustainability. As lower rates reduce the cost of funding, the near-term credit outlook of many of these companies could improve, while an accelerating transition to sustainability boosts their long-term credit outlook.
Finally, the shift from voluntary to regulatory standards such as the European Union Green Bonds Standard (EUGBS), which takes effect before the end of 2024, should enhance transparency and encourage increased issuance of GSS bonds.5 The EUGBS requires a close alignment with the EU’s taxonomy for sustainable activities and its six environmental objectives for sustainable activities.
The trend towards sustainability – It’s sustainable
We believe companies will increasingly pursue more sustainable business strategies, whether voluntarily or because of government or investor pressure. This should support the supply of sustainable corporate bonds, as well as growing concern over climate change and calls for stronger company accountability.
We see the near-term outlook for sustainable corporate bonds as constructive and encourage investors to consider diversifying their bond exposure into the more compelling sustainable bond asset class.
[1]Environmental Finance, March 2024
[2] Data from S&P, “Sustainable Bond Issuance To Approach $1 Trillion In 2024”, February 2024
[3]Bloomberg, as of August 2024
[4] Bloomberg: “U.S. Investment Grade Bonds Return 5.8% in Best Quarter of 2024”, 1 October 2024
[5] GSS: Green, Social, and Sustainability
