Historically, ESG investing has been mostly focused on the equity markets, but with around USD4 trillion of capital required globally each year just to contain the threat of climate change, it is inevitable that more money will need to come from bond investors.
This silent revolution will take place in fixed income markets over the next 5-10 years. Encouragingly, as the report illustrates, the fixed income markets look to be up to the task.
Within these markets, debt securities that embed environmental and social considerations are in the ascendancy. Albeit from a low base, the sustainable bond market has been growing rapidly for several years while the variety of instruments it contains and the range of environmentally oriented activities it finances have expanded at a dizzying pace.
“The development of ESG-labelled bonds is an area of the market we have been watching closely for some time. The analysis from IIF and Pictet Asset Management investment teams reaffirms our view that there is set to be a silent revolution in fixed income markets that will benefit investors, the environment and society.”
Green fixed income securities with specific use-of-proceeds requirements, sustainability-linked debt whose coupons are linked to the environmental performance of governments and corporations and social bonds are just some examples of the innovative structures vying to become mainstream investments in the next few years.
For investors, this transformation opens new frontiers and brings fresh challenges. The opportunity now exists to create portfolios that can fulfil both financial and non-financial goals – the mitigation of climate change, the protection of biodiversity and tackling inequality have become possible through bond investments.
There are risks to consider too. Due to their complexity, ESG bonds can be costly to analyse, requiring far greater scrutiny than their conventional counterparts. Nor do they currently fit neatly into the portfolio construction frameworks investors tend to favour.
“By 2025, there will be few global investors who don't have a significant allocation to ESG and green investments. And if you look further ahead to 2050—when governments and companies around the world will be seeking to deliver on net-zero commitments—we will have effectively greened global bond markets, transforming our environment for the better.”
ESG-labelled bonds are also likely to become bigger features of emerging world sovereign and corporate debt markets. ESG-labelled bond issuance in emerging markets will increase from some USD50 billion per year in 2020 to USD360 billion by 2023, according to the Pictet/IIF report.
Private capital is crucial to achieving the United Nations’ Sustainable Development Goals (SDGs) by 2030. The “SDG financing gap” – the difference between what emerging nations need and what they currently receive in investment – is estimated to be USD2.5 trillion per year.
At an estimated USD82 billion in 2020, the amount of climate-related investment channelled to the developing world accounted for less than 8 per cent of total cross-border capital flows into these countries. The development of ESG bonds could make a real difference; a fully-fledged sustainable debt market would provide emerging sovereigns and corporations with the capital they need.
Pictet Group Communications
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