A decade of Australian dollar GSS issuance: buy-side progress report

WARD After the first few deals, we expected the space would take off more than it has. Labelled issuance presented an interesting option for corporate credits. Even back then, there was lots of talk about transition finance, and we thought we would see more uptake from certain sectors – such as utilities. 

It seemed to offer a good way for borrowers that needed to transition to get the finance they needed for specific projects. Back then, however, we hadn’t appreciated the amount of work and cost that goes into structuring labelled transactions.

KELLY When the concept first came to Australia, I imagined it was going to be the beginning of a dialogue between borrowers and investors where we would start to see a clear link between the issuance of a green bond and the projects it financed. 

We thought issuers would create detailed metrics that would illustrate the financing of new projects in alignment with the label, and we expected annual figures on how many new projects the company had financed as well as information on how big the green asset pool had grown. 

Instead, issuers typically only update their green-bond pool when they are planning a deal. I thought labelled issuance would spark more than this. I expected it would be the catalyst to essentially create a link between an issuance programme and the generation of additional green assets that would continue to grow, independent of the bond.

CHRYSTAL I actually think the development of the market has been impressive, in size and breadth. Looking back 10 years, World Bank’s transaction was A$300 million (US$197.9 million) and green-bond issuance totalled A$600 million that year. Last year we had more than A$20 billion in green bonds alone, with issuers across corporates, financials, semigovernments and global SSA [supranational, sovereign and agency] names.

In saying this, if I had been asked to predict what today might look like, I would have expected corporates to account for a larger proportion of issuance. I also thought there would
be more uniform standards for reporting.

GALLAGHER I agree that the market demonstrates great progress by outright volume. If I had the chance to comment 10 years ago, however, I would have said I would like to see more names within that issuance. Last year, corporates issued about A$2.6 billion in labelled bonds, which is a little more than 10 per cent of the market.

What we like about the Australian market is its integrity. We don’t get issuers trying to pull the wool over anyone’s eyes. Issuers will do a two-week roadshow, talk to investors and give them the opportunity to meet and do due diligence. It is not like some overseas markets where a deal could be announced at 6am and print at midday. The Australian dollar green bond market is high quality and we are happy about this.

Since the first green bond, the Australian market has developed a broad range of products. A decade ago, I would not have expected so many different labels in what is a fairly embryonic market.
Can the market get better? Of course it can. There is a significant amount of demand for labelled securities, and supply can’t keep up. I hope we continue to see year-on-year growth and more issuers within the total pool.

VAN KLAVEREN As a European-based business with many European clients, when green bonds started here we were one of the biggest supporters. At one stage in the market’s infancy, we held 20 per cent of the Australian green-bond market in our portfolios.

Back then, we hadn’t considered whether we needed a green-bond fund, but we were getting directives from clients that wanted a larger proportion of our portfolio to be invested in green bonds. As the market has developed, this conversation has changed. Back then, the conversation was very focused on green bonds. Now, environmental, social and governance (ESG), sustainable investment and net zero are thought about more holistically. Labels are less important.

BISHAY We started investing in green securities many years ago. At the time, I had no idea the growth in the sector would be as strong as it has been, and I didn’t expect the level of sector diversification we have experienced. I have been pleasantly surprised. Right now, there is more than A$100 billion of Australian dollar ESG-labelled bonds outstanding. This is 7 per cent of the Australian composite bond benchmark. Only three years ago, it was only A$40 billion and 3 per cent of the index.

Last year, roughly 10 new issuers came to market, and the year before was about the same. When considering sectors in the Australian bond benchmark, we have 10 subsectors with ESG-labelled bonds and we are about to have 11 when the Australian government issues its green bond. I am blown away by the growth. Not only by the dollar number or the increase in exposure to the benchmark, but also by the diversification of sectors and issuers.

WARD I remember standing in the dealing room and just thinking ‘wow’. We would have bought the bond anyway – because we were buying supranationals at the time – but in our opinion it was marked slightly cheaper than the curve, meaning we effectively got paid a slight premium to go into it. I think the premium was partly for illiquidity – other supranationals were printing deals of A$1 billion or more. But it was still benchmark eligible.

At the time, there was not the same structure as there is now. But what was cool was that it was the first time I had seen a bond in the Australian market with such a clear line of sight to what we were financing. Until then, all bonds had been for general corporate purposes except for a few secured transactions. An issuer could use bond proceeds to pay a shareholder dividend. The green bond demonstrated exactly what was going to be financed.

Back then, we didn’t understand what a green bond was. In the intervening 10 years so much structure has been formed. The termsheet used to tell us what the use of proceeds (UOP) was, now we have frameworks that align with principles and guidelines, and experts at CBI [Climate Bonds Initiative] and ICMA [International Capital Market Association] who provide direction. They classify what types of projects are green, and it means we, as finance experts, don’t need to judge whether a style of solar panel or water treatment is truly green or climate aware.

There has also been the advent of second-party opinions (SPOs) and assurance statements. The first deal didn’t even have a requirement for ongoing reporting on the UOP. It was largely faith-based. So much has changed.

Our processes have evolved too. We never look at green bonds as separate assets – it has always been issuer first, structure second. But we now have standards for what we won’t accept. For instance, we don’t touch self-certified deals.

WARD Labelled bonds require a pipeline and pool of assets or projects, but corporates are telling us they don’t have the volume of assets needed to support benchmark-sized bonds. They don’t have the demand requirements for financing full stop. We have been through an extraordinary period in which corporate balance sheets have been strong and cash plentiful. Corporates haven’t had the borrowing needs we might ordinarily expect.

Then there is the cost of structuring these bonds. QIC has been on both sides of the deal, and the level of governance required does not make it a cheap exercise. There is the cost of maintaining the asset pool, reporting and paying for third-party verification. Unless a bond prints well through the vanilla curve I can understand why it hasn’t taken off on the credit side.

The AOFM [Australian Office of Financial Management]’s deal should be a game changer and might give confidence to issuers that have been concerned about the process or regulatory scrutiny of greenwashing to develop an asset pool.

CHRYSTAL Corporates are typically driven to capital markets when they have an additional funding need or upcoming refinancing and they either want to diversify away from bank loans or extend debt maturity, provided pricing is reasonable. For a GSS bond to happen, market conditions need to be right and the issuer needs a large enough asset base and to be advanced in its transition plan or be part of a suitable sector.

The typical deal size is A$200 million or more and issuers need enough green assets that require funding for the proceeds to be deployed. For an issuer to set up a new programme and framework, and go through the process of getting the assurance needed to make investors comfortable, there needs to be a recurring need as opposed to a one-off transaction. This makes it difficult for smaller issuers or companies in hard-to-abate sectors.

Even if an issuer is the right fit and market conditions are good, there needs to be an incentive. They will wonder why they should issue a GSS bond if they can issue a vanilla bond and not have to worry about greenwashing risk, the verification and SPO process, reporting and other extra work when there is no material pricing advantage or execution certainty.

GALLAGHER Not all corporates have massive teams to do this work, and we have heard some issuers need to hire someone to manage the reporting. This is a roadblock at the moment, but I think reporting will gradually become easier and the guidelines better understood. It is a virtuous circle. Some issuers haven’t even written a sustainability framework. Once all these things are in play it will be easier for issuers. Reporting is a burden, but it is what is required.

There are other factors: given the regulatory backdrop, it is hard to hold it against a treasurer or chief executive if a company issues regular bonds instead of green bonds.

Overall, there is growth. But it is the same sectors in the corporate world: universities, banks and utilities. We would love to see airports, ports and autos do deals in Australian dollars. Some of these names have written sustainability-linked loans, which says to us that perhaps these are easier to deal with from an issuer perspective because there are six banks rather than 40-odd bond investors.

Reporting has made it difficult, but the euro market is very strict, high-quality and well regulated – and billions of bonds are issued there every week. We are on a journey of breaking through the initial barriers and building confidence before everyone gets on board. Once we get there, we should see
the market kick away again. In the meantime, there are a few headwinds to work through.

GALLAGHER We spend a lot of time talking to issuers and we take them labelled bond ideas. We offer to cornerstone deals and we try to give broader access to our investor base so issuers can see not just our view but other institutional investor views about what we deem to be a good deal. We are trying to give them confidence to issue these securities. Some of these issuers have very large green asset pools already.

When will it start to change? I think it will be a snowball effect. Once a few deals get going we could see an avalanche. Last year, the corporate bond market in general had a dearth of issuance. It picked up late last year, and most recently we have seen a flood of deals. This is how our market works. One deal is done successfully, then syndicates get on the phone to rustle up other deals within that sector.

VAN KLAVEREN Green issuance is a way to support government entities: if their financing is tied to UOPs we know that, at least for that entity, we are supporting greening initiatives. Whereas for corporates, if there is a glide path target for carbon reduction and other social and governance objectives in place, does the issuer really need to issue a green or social bond as a proof statement?

We have gone from green-bond issuance as a percentage of the portfolio to an integrated ESG process. If a corporate issuer can prove its ESG credentials, and has strong targets and is recognised for them by investors, there is less need to issue a green bond – which can be quite costly.

GALLAGHER We run two strategies. One is a vanilla bond fund and the other is a green and sustainable bond fund. We treat ESG equally across both, except one can only invest in labelled securities and the other can invest more broadly. This makes labelling quite important for the labelled bond fund. But we apply a holistic ESG lens when looking at bonds for the corporate bond fund.

Fund specifics aside, the reason we think labels are good is because generally there is also reporting, which means we can quantify the impact bonds are having and feed this back to investors.

We need issuers to be holistically green. However, while some issuers don’t think they need to issue green bonds because their debt is green anyway, we think the reporting and granularity required to demonstrate impact as an issuer is important. It also sets up a blueprint within a sector for other issuers to follow.

We are looking for leaders within these sectors and it is leaders that are willing to issue green bonds. At the moment, I think this aspect is lacking in Australian dollars.

WARD A few years ago, I thought the labelled bond market would become more dominated by the government and SSA sector – as has happened – but also the banks. I thought they would be frequent issuers of labelled bonds, because in theory they could aggregate their underlying lending to corporates and issue in labelled format off the back of it. I am not surprised about the rest of the corporate market, but I have found the lack of acceleration from the banks surprising.

WARD I think a lot of the problem is regulatory scrutiny, privacy and compliance. If the banks aggregate loans into a bond pool and then there is a problem with one of the loans, there would be privacy considerations for the lending book that would limit how this could be reported on.

For instance, if a bank issued a sustainable bond and one of the sustainability-linked loans in the pool defaulted or missed a target, it may not be able to tell the bondholders because of the restrictions about sharing information from the loan. Issuance is hamstrung by compliance. It is much harder in bank deals to point to specific assets or projects.

VAN KLAVEREN There has been a greenium on certain bonds and at certain periods of time, but locally there is not a big push. Across the board, there is not huge demand among local investors for sustainable green product.

A lot of investors are happy with an integrated ESG process, whereas in Europe there was a big push for sustainable product and buying green bonds was one way to tick the box within a mandate – so a lot of bond funds moved into the space. This created more demand and outcomes where green bonds priced well inside some issuers’ secondary curves.

We don’t have these dynamics. Some funds have to buy green bonds. We have a preference for green bonds if the choice is between it and a nongreen asset. But clients are not asking us to have a certain percentage of green bonds or a green-bond fund. They care about carbon reduction targets.

There also are not enough labelled bonds in Australia to do it properly. If there were more labelled issuance, especially in the government space, perhaps it would be possible to have diversified exposure. For example, the AOFM is about to do a green bond – if there are more, and also from the semi-government and SSA sectors, perhaps it will be possible to have diversified exposure.

WARD There has always been reluctance on the part of investors to pay through the curve. Some feel they could be breaching fiduciary duties if they go into a deal that is not the best value based on the issuer’s curve, particularly if they are running a generic portfolio or mandate without specific ESG targets.

GALLAGHER We like to think that generating a greenium is not the primary motivation for an issuer to pursue a green bond, but I think it is possible to see a greenium the day a green bond is issued. We will look at an issuer’s curve and available data points so we have a good idea of where it should print, and green and sustainable bonds sometimes print through the curve and trade even tighter in secondary in the following days. When we check one or two months later, the bonds have reverted and just sit on the curve.

This doesn’t mean there isn’t a greenium. It just means the issuer potentially got a greenium the day it issued and the bonds have since drifted back to where they should sit.

The AOFM’s transaction will be interesting. It is only planning to issue A$7 billion, which is not a massive deal for the Australian government. I imagine the book will be 10 times that. I expect it will trade with a greenium on execution and, even if not, it should be well-bid post-execution.

Where it settles will be interesting. The AOFM has indicated it will not be too greedy with the price, but in the days following I think it should trade through the regular curve. The fact of the matter is there is more demand for labelled issuance than regular bonds, so issuers can be sharper in their pricing.

BISHAY There is a ‘halo effect’ when a corporate issues a green bond and it is not only from the bond investor perspective – it is also equity. If an equity analyst sees a company has issued a green bond, this will likely lead them to give an ESG tick – which ultimately feeds into the equity price. Whether or not the corporate treasurer can see the benefit via a slightly reduced interest payment, in my eyes there is a benefit.

The lack of a difference in spreads is due to market dynamics. We are not as advanced as Europe from an ESG perspective. When an ESG-labelled bond comes to the Australian market, there is only a handful of dedicated ESG buyers. The rest of the investors are vanilla funds. If dedicated ESG funds are not taking the whole deal and vanilla buyers get involved, this ensures the spread is closer to the vanilla curve.

WARD I think this was an argument a few years ago but there has been a huge swing in client and asset consultant expectations on incorporating ESG considerations into portfolios. ESG has mainstreamed into portfolios and in every client and asset consultant meeting, they want to know about the process and how their investments are contributing positively – regardless of whether or not we are running a labelled fund.

This shift has been driven by a couple of factors. Partly, it is a result of legal opinions on superannuation trustee and director duties extending to certain elements of ESG and APRA [the Australian Prudential Regulation Authority]’s guidance on obligations to consider climate risk. These are game changers in that it begins to get attention at the top of organisations. This has really changed the narrative, even for vanilla bond mandates.

WARD When I started my fixed-income life for QIC more than 20 years ago, I remember a discussion with one of the portfolio managers about a British American Tobacco bond in Australian dollars. With my lawyer hat on, I decided we needed to buy the bond – it was the early 2000s, lots of people still smoked and it was hard to imagine any default risk purely based on financial return. Meanwhile, the other portfolio manager argued against it on health grounds. I viewed his as a personal view and mine as our fiduciary responsibility to invest.

My career has seen a complete turnaround. Governance has always been a feature of credit analysis: some of the old defaults and insolvencies of big companies had a lot to do with poor governance and financial rules that allowed fraud. But thinking about the ‘E’ and the ‘S’, and incorporating them into the investment process, including whether these issues could increase refinancing or capex costs, is now part of the process when analysing credit. It has become one of the basic expectations clients have.

KELLY Our funds under management has grown significantly in the last 10 years. End investors are increasingly aware of what they are invested in, and they query the methodology applied – for example, they are asking if they are being inadvertently exposed to harmful investments due to a best-of-sector approach, or because ESG integration is being used that still includes companies they didn’t expect.

This theme, however, has been much more prevalent in equities. This is partly because of demographics. There is a skew toward equities among younger investors and they tend to be the most engaged on ESG issues. They are the ones coming through on social media to query the specifics of individual investments we are involved in.

But while it is still at the low end, interest in ESG for fixed income will continue to increase – particularly as issuers attempt to engage with the market on these issues. We view labelled transactions as an issuer’s attempt to engage with the market in a discussion about how it views itself as a responsible investment.

While we are a dedicated responsible investor, our Australian Ethical Fixed Interest Fund, for instance, is not a solely green or labelled issuance targeting fund and does not carry a target weight within the fund to allocate to labelled issuance.

WARD The market has moved away from ESG being applied via labelled funds. It is understood that a portfolio can have strong ESG credentials based on the credentials of the credits and not just because it is full of green or social bonds. Part of this is the mainstreaming of ESG.

There also aren’t enough labelled bonds for investment purely based on a label to work at scale. For instance, when concerns were raised about Hyundai bonds two years ago
due to modern slavery issues, we were able to trade out of our position – including green bonds. There have been a few occasions like this – where we have said ‘our clients aren’t going to want to be seen financing this’ based on an ESG concern – and as a result we have got out of the position or engaged with the issuer.

VAN KLAVEREN All our funds have an integrated ESG process. We effectively score each issuer on a standalone basis to form an ESG score between 1 and 5. We then seek to buy the better ESG companies and exclude or eliminate the poorer ones, based on the risk assessment. This seems to be a process clients are happy with.

Within this framework, if we are very comfortable with a company’s credit rating, fundamentals and pricing, and we can buy a green bond, we will do so. But there are not a lot of green bonds to buy in the corporate space. The integrated ESG approach, meanwhile, means we don’t need green bonds to get solid ESG credentials.

GALLAGHER Our green-bond fund is growing twice as fast as our regular bond fund. There is a lot of appetite within certain parts of the market. In the retail space – the average financial advisory firm that deals with everyday clients – investors are telling us their clients are interested in ESG and they want
to know advisers have products within this suite. But it is not always top of the list for where this cohort wants capital allocated when it comes to making an investment.

Then there are bigger, high-net worth, family office advisories, dealing with clients of A$2 million and upwards. These clients have a lot more interest in ESG strategies. There are more environmentally-conscious investors within family offices – which is usually the younger generation coming through and seeking to invest more sustainably.

There are obviously ethical superannuation funds within the superannuation industry, which we have as investors in our funds. Other superannuation funds are still working out what they want to do in the space. Buying some high-grade green bonds and having an allocation to the asset class is the starting point. Others are on a different journey, deciding whether to allocate ESG out or manage it internally.
There are varying degrees of interest within the market, but the common theme is that everyone is interested. If I send out 10 emails about the corporate bond fund and 10 about the green-bond fund, I will probably get eight replies on the green and maybe one or two on the corporate. Even if clients don’t want to invest, they want to understand it.

BISHAY Our most popular products in terms of flows over recent years are dedicated ESG products. We were involved early with our ESG strategies, and the way we market our fund, what we’ve done with our impact database and the way we present positive impact has really resonated with clients. It is a combination of strong performance over time and how we present the outcomes of the projects we are involved in.

VAN KLAVEREN End investors want to see impact from their capital. They want an integrated ESG approach and to be able to see carbon reduction. They have less demand for a badge that says green or sustainable investment. The process is about trying to invest in the best ESG-based companies – the ones that either have good credentials now or a glide path to a better outcome.

Negative screens and exclusions are a factor. But the challenge is that, if the objective is simply to reduce the carbon score over time, certain entities could just be excluded. Excluding power utilities, generation and distribution would lead to a dramatic reduction in carbon emissions across the portfolio. But if we are going to transition to green energy and no-one invests in power utilities, they are going to struggle to do what they need to do.

We chat to clients about this dynamic and what impact means. We could leave companies like this out of the portfolio, and it is not strictly our problem. But it doesn’t leave the world better off, it just makes the score better. We work with these companies and engage in stewardship to help them make a change.

VAN KLAVEREN We like the SLB concept but the journey the market has been on has not done it any favours. In its infancy, a lot of syndicate teams were reaching out with a model under which the investor would get a market coupon that would step down if the issuer met certain objectives. There was a benefit but no punishment – if the issuer failed, it would still pay a market coupon.

Then we moved into the idea of step-ups. But 25 basis points is not a huge rap on the knuckles for not achieving a goal. Likewise, there have been problems regarding the ambition of targets. They are often focused on emissions intensity rather than absolute emissions.

The test dates have also been too far out – if a company issues a 10-year bond and the test date is in year eight, it is a long time for us as an investor to sit and wait. There should be earlier tests and more punitive costs earlier in the process. We might not even own the bonds by that point.

Internationally, there have also been issues with legality and the binding nature of the tests. In some cases, weak documentation has led corporates to argue against failed tests. The other thing we are wary of is the organisational structure: in some cases offshore, SLBs have been linked to a sub-unit of the business rather than the whole entity.

KELLY By substituting the UOP language and linking a bond to sustainability performance targets, issuers can further detach the volume of a bond they issue from the size of the impact they seek to make.

Issuers set the SPTs [sustainability performance targets], often prior to engaging with investors on a roadshow. The lack of dialogue between the investor community and the issuer on targets means end investors’ ability to do good through investing in labelled issuance is even more hypothecated than it is for UOP bonds. There is less of a clear link between investing in the bond and the outcome it contributes to.

There is also the slightly odd outcome where the coupon step-up comes through if an issuer fails to meet a sustainability target and, in effect, the investor is rewarded for a bad outcome. This is not what investors want when they invest in an instrument like this.

There have been fewer SLBs partly because there is a lack of understanding about the link between what a company says is it going to do with the proceeds and the SPTs it sets. There is a question of whether they would have these targets in the absence of the bond issue and whether they would have achieved them anyway.

BISHAY As long as it is a stretch target and the issuer has genuinely committed to environmental change, we are very happy to look at SLBs – assuming the issuer can’t do a UOP transaction.

However, I think SLBs are difficult for issuers to justify. Is the reputational risk of missing a target worth it? This is why it hasn’t kicked on. I like the concept of SLBs, though – especially as a whole bunch of issuers can’t issue a green bond or social bond as they don’t have the underlying projects to back the deals.

CHRYSTAL Labelled bonds have a role to play as they bring more scrutiny on companies’ sustainability strategies, raising the overall base level. I expect green bonds to be more widely distributed as issuers advance in their sustainability journeys, and investor knowledge and level of comfort increase.

We hope there will be more guidelines for transition bonds to help develop this market and add another option for issuers. The path to net zero cannot rely on the best-in-class alone – it must include all companies.

VAN KLAVEREN UOP bonds and SLBs could play an important role in future. Even though our funds aren’t labelled sustainable, there is still core appetite to buy and support these bonds. Overall, though, it is less about the label and more about the outcomes. We are most supportive of the impact side and any instrument that helps in this process is one we want more of.

KELLY We would like to see more UOP issuance. Labelled issuance will be a feature going forward. But we hope there will be a narrowing in the look-back and look-forward periods on UOP bonds so we can tighten the connection between bond issuance and the assets they fund.

CHRYSTAL Success can be defined as the ability for each issuer, regardless of how far along the ESG journey they are, to have the right instrument to issue to help fund it to move forward. This might mean different types of bonds – including transition bonds.

Clear pricing differentiation between labelled bonds issued by companies with strong sustainability plans, labelled bonds only issued for optics purposes and vanilla bonds would be a sign of the market having matured enough to discriminate not just among instruments but also issuers.

KELLY I have four points. Number one: we would like to see more issuers in the corporate credit space and repeat issuance in labelled format from these issuers. We want to unwind from the one-and-done approach.

Two: we want an expansion in the number of investors that target issuance in labelled format. Because this will lead to my next point, which is, three, the evolution of a greenium – not as an end in itself but because there is increased demand in the market for labelled bonds. Number four: we want to see tightening in the use of proceeds.

VAN KLAVEREN Issuance is very narrowly based and is mostly green. We like social bonds, especially supporting social housing, and would like to see more of these. There are lots of social schemes out there, and we want to partner and support them. There are social assets within some semi-government sustainability bond issuance, but we would prefer to see more direct linkage. Otherwise, it is just a pot of green.