Investors are confident that ESG and sustainable bonds will bounce back after a torrid 2022, citing rising demand and significant global regulatory drivers.

Fixed income markets were hit by rapidly rising interest rates amid soaring inflation, sparking one of the worst-ever selloffs last year.

Sustainable bonds were among the hardest hit, notably underperforming their traditional counterparts for the first time since 2018. The S&P Green Bond index, which tracks about $1.4tn in bond issuance from governments, agencies and companies worldwide, fell by 20.1% in 2022, compared with a 16.7% drop in the wider global investment grade universe.

Morgan Stanley put a lot of this underperformance down to sustainable bonds’ typically longer duration, with the S&P Green Bond index having an average duration of 10.5 years.

‘In fixed income, the broader market response to increasing rates in 2022 favoured funds focused on shorter durations. This investor shift impacted sustainable funds, which tend to skew toward long durations,’ the bank said in a note.

‘Also notable is that green bonds tend to favour utilities and financials, which both underperformed in 2022.’

ESG bond issuance also fell against the tough market backdrop – exacerbated by scepticism about the effectiveness of sustainability-linked bonds (SLB) – slumping 33% on the year to $750bn, according to S&P data.

Brighter outlook

Despite the storm clouds over the market, demand remained strong. Globally, ESG bond funds saw inflows of $21bn in 2022, compared with $499bn in outflows from traditional bond funds, according to Bank of America. Total ESG fund assets still dropped to $490bn, though, down from $545bn in 2021, due to the market moves.

Bulls point to cheaper valuations after last year’s selloff and signs that inflation has peaked, raising hopes that the end of the rate-rising cycle is in sight, which will provide a more positive macro backdrop.

Johann Plé, green social and sustainability bonds strategy manager at Axa Investment Managers, believes there are ‘reasons to be optimistic about the asset class’.

‘The long-term picture looks more and more compelling for the bond market and should be particularly beneficial to the green social and sustainable bond universe given its credit exposure and sensitivity to interest rates,’ he said.

Plé is also backing mounting regulatory momentum and growing awareness of social and climate challenges to boost demand.

This is echoed by Julien Bras, socially responsible investing fixed income portfolio manager at Allianz Global Investors.

‘Demand from investors for more ESG fixed income opportunities is growing globally, especially as investors and regulators have increased pressure for companies to carry out better disclosures and practices,’ Bras said.

Rising demand

S&P predicted last month that green, social, sustainable, and sustainability-linked bond (GSSSB) issuance will increase by 5-17% to $900bn-$1tn this year, close to the record $1.06tn issued in 2021. This compares with the research house’s expectations of a 2.5% increase in issuance in the wider global bonds market and would see ESG-focused bonds account for 14-16% of total bond supply.

Doubts remain about the SLB sub-sector (bonds linked to specific sustainability objectives). Issuance dipped 25% last year on worries about ‘the credibility of the asset class’s ability to achieve meaningful sustainability targets’, S&P said. But the ratings agency believes the greater flexibility and simplicity that the bonds offer could still help ‘broaden the base of issuers of sustainable debt… if credibility is addressed’.

Even with concerns about SLBs, the signs for the wider ESG bond market are encouraging this year. TD Waterhouse highlighted a 40% year-on-year increase in global ESG bond issuance to $93bn in February. Corporate supply rose 51%, while green bonds accounted for 55% of overall supply, up from a long-term average of about 40%, as SLB demand remained subdued.

The slew of green bond issuance included a $5.75bn raising by Hong Kong in January, the highest ever for a sustainable bond in Asia. India pulled about $1bn into its first-ever sovereign bond and countries as diverse as Slovenia, Ireland and the Philippines also came to market.

Axa IM counted 115 new corporate issuers of green and sustainable bonds last year, adding depth to the market. Plé said there was notable issuance in the real estate, consumer goods, automotive and telecoms sectors, helping managers to build diversification.

Challenges still remain for ESG bond fund managers, however, as was seen last year in their relative performance.

Mitch Reznick, head of sustainable fixed income at Federated Hermes, emphasised the importance of the universe becoming deeper. He said: ‘[Sustainability]-themed funds will have sector biases in the short term versus a mainstream benchmark, [so] there will be some level of performance volatility.’

Archie Beeching, director, responsible investing at Muzinich, believes that disclosure also needs to be addressed. He said: ‘There is plenty of data for investment grade issuers, including in emerging markets, but less so the further down the credit spectrum you go,’ and in private companies.

There are multiple regulatory initiatives under way that should improve demand and existing challenges such as disclosure.

The EU reached a provisional agreement on a European green bonds standard in March, designed to provide a ‘green standard’ for transparency. The likes of Brazil, Thailand, Malaysia and Columbia are also working on taxonomies to ensure products are properly defined.

Elsewhere, Axa IM expects the US Inflation Reduction Act to drive higher issuance by incentivising corporates to change their behaviour.