Sustainable Bond Market: Quo vadis?

With a new issuance volume of approximately USD 228bn in the first quarter, the Sustainable Bond market has gotten off to a solid start in 2023. A glimmer of hope after the challenging year of 2022?

In recent years, the Sustainable Bond Market has only known one direction. “Forward ever, backward never”, was the undisputed motto. Even at the epicenter of a pandemic in 2020, in which Social and Sustainability Bonds soared, the Green Bond segment, which had initially slumped in a tremendous way, fought its way back to new heights. Hence, at the beginning of the year, no one doubted that the success story of the labelled bond market would continue in 2022.

However, in 2022, for the first time in more than a decade, the Sustainable Bond market saw a decline in new issuance volume by -23% affecting every single segment. The new geopolitical reality led to tough fixed income market conditions which these labelled bonds have never faced before: rising energy and commodity prices, a global inflation surge, the end of a decade of ultra-low interest rates.

While the mature Green Bond segment proved relatively resilient with a decline of only around 13%, new issuance volumes of Sustainability Bonds (-21%), Target-linked and Transition Bonds (-37%) and Social Bonds (-44%) were less immune to the rough market conditions. With a share of 60% of new issuance volume in the Sustainable Bond Market, the Green Bond segment hence proved to be a solid anchor in turbulent times.

The negative surprise of the year was without a doubt the fall in Target-linked Bond issuance - both in volume and market share. The 2021 darlings have had a tough time, especially in the second half of the year, as fears increasingly emerged that such a structure could expose issuers to potential legal risks. In addition, the voices of critics among investors and banks grew louder, flagging greenwashing concerns about Target-linked debt.

Despite a tough and volatile market environment, there were also bright spots in the Sustainable Bond market. The new issuance volume of Sustainable Bonds in 2022 declined less sharply than that of traditional bonds. The share of new Sustainable Bonds issues in the overall debt capital market therefore continued to rise to around 18% in 2022 (2021:15.8%). Furthermore, Sustainable Bond issuance from financial institutions surprisingly increased by approximately 21% to around USD 187.5bn. Thanks to its dynamic and resilience the Green Bond segment hit the USD 2tn milestone (cumulative issuance since the kick-off of the segment in 2008) at the end of the third quarter.

Return to qualitative growth

The overall bond market appears to be in a much more promising position than it was last year. However, the uncertain macroeconomic outlook and persisting geopolitical risks should still be a concern for fixed income investors. Hence, we do not expect the new issuance volume in the Sustainable Bond market to go through the roof in 2023. It will not be until 2024 before the Sustainable Bond Market sets off for new record heights in growth rates.

However, as investor appetite for Sustainable Bonds remains strong, we expect a gradual return to growth in all segments of sustainable debt in 2023. It will remain a growing portion of overall issuance and we expect Sustainable Bond issuance to outperform the broader bond market once again in 2023.

We forecast further diversification both by issuers and themes. Investor interest in Sustainable Bonds remains high. There is still too much demand chasing too little supply. ESG integration in portfolios is further on the rise. And it goes far beyond climate issues. Investors are also increasingly looking at nature-related issues or social issues in their fixed income engagements. Improving market conditions ensure that maiden issuers who deferred their sustainable funding in 2022 regain confidence and come to the market with their inaugural issues in 2023. We also expect to see a further pick-up in issuance from emerging markets.

According to our forecast new issuance volume in the global Sustainable Bond market will rise by around 36% to surpass USD 1tn in 2023 (2022: USD 740bn; 2021: USD 957bn). In contrast to some record years in the past, this regained growth will be qualitatively rather than quantitatively driven. We forecast that the share of new Sustainable Bond issues in the overall market will rise to around 20%.

With an estimated share of 62% the Green Bond segment will remain a guarantor of growth in 2023. We expect new issuance volume to increase by almost 40% to around USD 620bn. The new geopolitical reality revealed that accelerating the energy transition is not only key to tackle climate change but that it is also pivotal to ensure energy security. Hence, growth in the Green Bond segment will be supported by the policy push towards low-carbon energy projects in key regions like the EU and the US. Furthermore, we expect that nature-related risks will move up the agenda of Green Bond issuers and investors. By putting Sustainable Development Goals like “Life on land” and “Life below water” into the sustainable funding focus, the foundation is laid for more and more biodiversity-focused transactions. Growth of the Green Bond segment is also backed by supportive polices and regulations around the globe. Further steps by the ECB to incorporate climate change into its monetary policy, the launch of China’s Green Bond Principles or the Inflation Reduction Act in the US are only a few examples.

We expect market participants to rediscover their interest in Targetlinked structures. We are confident that issuers and arrangers can address the growing concerns of this instrument by focusing on Key Performance Indicators (KPIs) that are material to the business model of the issuer and ambitious Sustainability Performance Targets (SPTs) to enhance the quality of Target-linked financing via the fixed income market and thus its credibility. Target-linked instruments play a key role in transition finance and the need for it to successfully implement the Paris agreement is undisputed. We cannot achieve a decarbonized and more sustainable world by focusing exclusively on economic activities, business models and sectors that are already ‘dark green’. We can have a much greater positive impact on the global sustainability agenda by helping tomake ‘brown’ economic activities, business models and industries ‘light brown’ or ‘light green’, rather than painting already ‘dark green’ activities, models, and sectors one shade greener. Furthermore, Target linked structures are also very suitable for addressing biodiversity issues in funding, as it is often challenging to define what a biodiversity asset or project is. Another argument for qualitative growth of Target-linked instruments, is the growing appetite of investors for a mix of Target-linked and Use-of-Proceeds structures. Austria’s Verbund AG, one of the largest producers of electricity from hydropower in Europe, has issued in March 2021 the world’s first bond combining Use-of-Proceeds and KPIs: a so-called “Green and Sustainability-Linked Bond”. Recently the Dürr Group, one of the world‘s leading mechanical and plant engineering firms, has issued a Green Schuldschein whose proceeds have been earmarked solely for sustainable product innovations and climate-friendly projects and whose coupon is in addition tied to Dürr’s sustainability rating. We expect other issuers in the Sustainable Bond market to follow these examples.

We forecast a strong pipeline in Sovereign Sustainable Bond issuance as a couple of maiden issuers like Brazil are waiting in the wings to come to the market this year. Sharjah’s recent sustainability debut gave an impetus for Middle East, and we expect other sovereigns in the region to line up for issuing Sustainable Bonds and sukuks. Sovereign issuers already established in the market are looking to expand their sustainable funding activities, such as Indonesia, which is planning to issue a Blue Bond. Sovereign Targetlinked Bonds are becoming increasingly popular among smaller sovereign issuers. Following the success of Chile and Uruguay, it can be assumed that the instrument will establish itself in the market beyond Latin America and that we will also see issuances from Southeast Asia, for example.