Fisch Asset Management AG,
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Executive Summary
- This paper explains the background behind the sharp increase in issuance of sustainable convertible bonds, which has been fuelled by investor awareness and appetite.
- We categorise the different types of “green” bonds that have emerged, with the amounts raised linked to either specific projects or performance targets. An understanding of the pay-off structure relating to each specific security is essential.
- Different types of structures and issuers create a heterogenous pricing environment for sustainable convertibles, but, on average, short-term performance following the initial offering has proved positive. We analyse the performance drivers and what role the pricing of issuance plays.
Following the trend in traditional fixed-income markets, issuance of sustainability-driven bonds within the convertible bond (CBs) asset class has grown exponentially in recent years. In 2020 alone, more than USD 5 billion of ESG-related CBs were issued – a jump of around 1000% compared to the prior year. 2021 was another record year, with the level of issuance growing by 86% to USD 9.9 billion. All in all, ESG-linked CBs accounted for around 7.4% of the total issuance in this space in 2021 – a number we expect to increase further in the coming years.
Given the level of interest from investors desiring a stronger tilt towards ESG in their portfolios, this development is welcome news. However, looking at anecdotal evidence and, given the extraordinary demand for these types of bonds, there may be a catch: Some market participants see these bonds potentially priced as too expensive and less interesting in terms of structure, resulting in a potential drag on overall return performance.
In the following sections, we have compiled our analysis of the recent ESG issuances in the CB asset class. The aim was to assess whether sustainability does indeed come at the expense of inferior structure, and whether investors simply have to accept below par performance as a trade-off.
Exhibit 1: Aggregated amount of recent ESG-linked CB issuance (USD bn)
Source Bloomberg, Fisch Asset Management
Overview: The new types of ESG-linked convertible bonds
Complementing green bonds, which have created more investment opportunities within the ESG-linked space, new issuances have taken various forms, which we explain in more detail below.
Green convertible bonds
Issuers specifically use the amount raised to finance climate-related or environmentally linked projects. Most of the issuers in the CB space issuing green bonds are in the renewable energy space, electric vehicle (EV) production or in its value chain (mining of rare earth minerals for EV motor magnets, for example). Green CBs are the most common type among ESG-linked securities in this asset class.
Social convertible bonds
This type of ESG-linked bond is rarer and issued by companies that have their corporate social framework aligned with the Social Bond Principles (SBP21). Proceeds of the issuance must be used for new or existing projects with positive social outcomes. The achievement of the intended goals is typically self-reported, so investors need to be particularly discerning.
One example relates to a healthcare company raising capital to achieve a stable supply of safe and secure medical devices (dialysers) for patients to stay alive and enhance their quality of life. These projects are aligned with the “Access to essential services” SDG category as defined by the SBP21.
Sustainable convertible bonds
Companies sometimes pursue projects with environmental benefits which may also confer social enhancement (and/or other dimensions in the Sustainable Development Goal framework). In these instances, a sustainability bond finances projects that aim to achieve a more overarching positive outcome to society without being tied to very specific green or social objectives.
Examples include bonds that have been issued to invest into better access to education or more energy-efficient and affordable housing, tying environmental and social outcomes together.
Sustainability-linked convertible bonds (SLCBs)
SLCBs are innovative bonds issued with specific sustainability performance targets (SPTs), aligned with the issuer’s sustainability strategy. The bond structure contains key performance indicators (KPIs) to reach within a specified time frame, for example “percentage of recycled materials used in manufacturing by target year 2030”. If the target is missed, the bond is subject to a “step-up” clause, meaning the bond coupon increases.
The uniqueness of the structure lies in the fact that, unlike traditional green and social bonds, a sustainability-linked CB is not solely associated with a specific project. As such, the proceeds can be used for general corporate purposes, while the company endeavours to reach the specified KPIs.
Are ESG-linked CBs issued at a premium?
We analysed every ESG-linked convertible bond issued in the last four years and compared them to the overall universe for the purposes of highlighting any specific discrepancies. For this exercise we defined a comparable universe as comprising all non-structured, non-preferred vanilla CBs issued in the last four years, which are actively traded with a minimum issue size of USD 50 million. This is to ensure an objective basis for comparison in line with the relevant opportunity set for convertible investors.
Exhibit 2: Average issue size per ESG-type among CBs (USD m)
Source Bloomberg, Fisch Asset Management
Issue size is one of the key factors to ensure adequate liquidity in the secondary market. In this respect, ESG-linked bonds are, on average, issued at a larger size of USD 565m (versus USD 455m for the overall universe). With the overall amount issued increasing each year, this is testament to investors’ growing familiarity with the structures as well as the pedigree of the companies coming to the market with ESG-linked bonds.
Exhibit 3: Average initial premium size per ESG-type among CBs
Source Bloomberg, Fisch Asset Management
The initial premium (amount by which the price of a CB exceeds the current value of the stock into which it may be converted) for a CB in the primary market is important as this will be a key component of future price behaviour. A high premium at issuance will dampen the subsequent price appreciation of the CB compared with the underlying equity performance. Given the appetite in the market for sustainable bonds, one would expect to see uniformly higher premiums embedded in these structures. However, our analysis does not show, on average, a meaningful difference compared to the non-ESG-linked universe. Nevertheless, we can see more divergence within specific sub-sectors.
More specifically, Green CBs were historically issued at a discount of circa 4% in terms of initial premium. We believe this to be the case because of two main reasons: First, the Green CB universe comprises younger companies with less mature business models than average, and second, the capex-intensive nature of most business models (renewable energy investment or EV manufacturer) results in balance sheets that are more stretched than average. We therefore view this discount to be fully justified in order to compensate investors for the additional risk.
On the other hand, we saw some ESG leaders (companies traditionally well perceived/rated by the market and by third-party ESG rating providers) issuing sustainability-linked CBs that came out at a 10% premium versus the market (initial conversion premium approximately 10% higher vs market average). In our opinion, the good standing of these companies among investors as well as the commitment to achieving tangible and measurable SDG-defined targets were rewarded by the market in the form of higher conversion premiums. However, while welcome, we have yet to see clear evidence that the potential step-up in coupon has acted as a true pricing driver.
Exhibit 4: Average coupon per ESG-type among CBs
Quelle Bloomberg, Fisch Asset Management
The same argument can be made about the average coupon paid by the issuers of ESG-linked convertible bonds. If Green CB issuances, traditionally undertaken by smaller and more indebted companies, have coupons broadly in line with the market, it is worth noting that, thus far, neither Social CBs nor Sustainability-linked CBs have paid any coupons. Again, we assign this observation to the quality of the underlying companies within the social/sustainability-linked space, while equating greater market appetite with the creation of incentives that are slightly tilted to the benefit of the issuer at the detriment of the investor.
If we adjust for the credit risk by comparing coupons paid across a similar rating level, we can identify that Green CBs have historically stood out in providing bigger coupons relative to their comparable risk-adjusted convertible subset. However, it is interesting to note that this trend has reversed over recent years. At equal level of credit risk, it appears that issuers of Green CBs can now raise debt at a lower interest expense. We attribute this fact to the higher level of interest from investors as well as the shifting composition of the Green CB universe. Whereas they traditionally came from the energy or renewables space, we are witnessing more and more electric vehicles manufacturers issuing green CBs, where structures are skewed more towards the benefit of the issuer.
Exhibit 5: Coupon differential for Green CBs adjusted for credit risk
Quelle Bloomberg, Fisch Asset Management
Relative performance of recent ESG-linked CB issuances
What stands out more than the differences of CB structures is the potential for ESG-linked bonds to deliver superior relative returns versus their conventional peers. In fact, our analysis points to a specific short-term relative positive price action following the issuance of an ESG-linked CB:
ESG-linked CBs posted on average an outperformance of +1% during the first month of trading relative to the broader universe. Over three months, the outperformance was even higher: On average, ESG-linked CBs returned +5.1% excess performance over the Refinitiv Global Focus index. This is consistent across all sub-types of ESG-linked CBs and all observation periods, with the exception of Sustainability-linked CBs, which traded relatively lower over one month versus the overall market.
Methodology: For each security, the relative performance was computed as the return over one month and three months from the issuance date relative to the return of the Refinitiv Global Focus index in USD over the same period of time. Any recently issued security without sufficient time period performance data was removed from the analysis.
Exhibit 6: Relative performance of ESG-linked CBs over the first month since issuance vs. the Refinitiv Global Focus index
Source Bloomberg, Fisch Asset Management
Over the first month of issuance, the relative average performance of ESG-linked convertibles has been mostly positive with an average of +1.2% relative return over the Refinitiv Global Focus index. The low average is driven by the relative underperformance of the 2021-issued Green bonds, which are the largest constituents of our dataset.
Exhibit 7: Relative performance of ESG-linked CBs over the three months since issuance vs. the Refinitiv Global Focus index
Source Bloomberg, Fisch Asset Management
Over three months, the relative performance of ESG-linked CBs stands, on average, at +5.1%* supported by all sub-types of sustainable convertibles. What is notable is that there is a common feature relating to the performance of these new CB issues: despite them being issued at different dates and therefore in different market environments, their performance in the short-term has been positive in most cases.
This strong relative performance underscores the attractiveness of this market segment for investors, as, not only did valuations hold up in the secondary market, the underlying equity also acted as a driver of alpha generation.
*This performance calculation excludes the outlier relative performance of +147% of the Enphase Energy Green CB.
Conclusion
ESG-linked CBs are a welcome addition to our universe as investors are seeking more ESG investment opportunities across all their asset classes. Also, without equity voting powers, it is often difficult for CB investors to actively engage with issuers. This new and growing generation of ESG bonds, clearly linked to sustainability, opens up opportunities for more active engagement with the potential to achieve tangible improvements.
We are encouraged by the fact that the technical profiles of ESG-linked CBs have proved to be consistent with the overall market. The exceptions to this rule are SDG-linked CBs that turned out to be more expensive in terms of initial premium for investors, and the relative coupons of Green CB issuances deteriorating. But, in both cases, this was compensated by above-average returns.
Nevertheless, not every issuer in the space has managed to deliver returns in line with investors’ expectations or market level. We believe that active management coupled with comprehensive ESG analysis is needed to ensure successful stock selection in this sub-segment of the universe, which should benefit from increased investor appetite and regulatory tailwinds.