Green bonds have gained attention due to their alignment with ESG goals, making them a key consideration for environmentally and socially conscious investors.

In this podcast episode, Paul O'Connor, Head of Investment Management at Netwealth and George Bishay, Head of Credit and Sustainable Strategies at Pendal Group delve into the universe of green bonds. Their discussion explores the role of green bonds in investment portfolios, their impact, market performance and their role in portfolio diversification. The conversation addresses the vital issue of greenwashing, how they ensure credibility of green bonds and the significant role they play in responsible investing.

Transcript

Paul O'Connor:

Good morning all and welcome to the Netwealth Portfolio Construction Podcast series. My name is Paul O'Connor and I'm the head of strategy and development of investment options for Netwealth. This morning's George Bishay from the Pendal Group joins us for today's podcast. George is a portfolio manager of credit fixed interest and enhanced cash portfolios and has significant experience in portfolio management and credit analysis with a specific focus on asset-backed securities, industrials, real estate and the resource sectors, and has also held dealing roles. He's been with Pendal for 29 years and has also worked in an accounting role for three years. George obtained a master's degree in business finance, a bachelor's degree in business, and a graduate diploma in applied finance and investment. He also has a registered representatives and dealer accreditation with the Australian Financial Markets Association. George has managed, dedicated sustainable fixed interest portfolios for a decade, including the sustainable Australian Fixed Interest Fund.

So for today's podcast we'll focus on green bonds and the growing opportunity to invest in ESG fixed interest strategies. Good morning George and welcome to the Netwealth Portfolio Construction Podcast. Uh, good morning and thank you very much for having me today. Pendal Group is an ASX listed investment manager actively managing strategies across Australian equities and listed property, Australian and international fixed interest, global equities, multi-asset portfolios and alternative investments. As at 30 June, 2022, Pendal had total assets under management of $111 billion. The business also includes Jo Hambro Capital Management, a London based manager of global and regional equities, portfolios and multi-asset strategies and renan a provider of ESG research engagement and advisory. In 2023, Pendal became part of perpetual Limited that resulted in a merger of two of Australia's oldest and largest active asset businesses. There are 14 Pendal managed funds on the Netwealth Super and I D P SS menus covering Australian equities, international equities, and Australian fixed interest, including the sustainable Australian Fixed Interest Fund and the Renan credit impact Trust that George is the portfolio manager of the growth of environmental social and governance or E S G investment strategies over the last decade has been significant and in particular the wealth management industry has increasingly allocated to these strategies over the last five years.

George Bishay:

E S G strategies originally focused on Australian and international equities, but in recent years we've seen more fixed interest E S G strategies being issued by managers that invest in green bonds. A green bond is essentially a fixed interest security that invest in climate and environmental projects. My understanding is that climate bonds specifically finance projects that reduce carbon emissions or alleviate the effects of climate change. Whilst green bonds represent a broader category of securities related to projects with a positive environmental impact. But we will let the expert George explain what his definition of green bonds are. Recent market volatility has been driven by inflation and rises in interest rates and this has resulted in flat or negative returns for many fixed interest securities. So I'll be interested in George's views as to how green bonds have performed against the wider fixed interest investment universe over the last 12 months or so.

Paul O'Connor:

Traditional fixed interest portfolios invest in as many bonds issued by different entities in an attempt to reduce credit risk in a portfolio. So we'll be interested to understand how big the green bond universe is compared to the broader fixed interest universe and if there are any additional risks to investors using these strategies in their diversified portfolios. I note in 2012, green bond issuance amounted only to about us $2.6 billion, but by 2017, green bond issuance soared to a record high of us 161 billion according to ratings agency Moody's. And this growth continued with issuance reaching $266 billion US in 2019 and then nearly 270 billion in 2020. So there appears to be a significant growing opportunity set for investors. So perhaps for starters, George, can you explain to the listeners how you developed a focus on green bond strategies and what attracted you to this area of investing?

George Bishay:

Yeah, it was interesting, but I started managing, I guess E S G fixed income funds in 2009. So it's been a while now just managing those dedicated relative to vanilla strategies, which I managed prior to that. But where the interest came about was there was very much a focus on negative screens back in the day and there was lesser focus on how to actually find solutions. And then basically there was these green bonds that started issuing, um, you know, it started in 2011 and then 2014, but when they started issuing, we're actually looking at these bonds and we actually thought these are perfect for these types of E S G funds that I'm running. And the great thing about these specific green bonds, uh, that we invest in at the end of every year from issuance, they actually give you something called an impact report, which talks about the positive benefit you are having via your investments, whether that's renewable energy generated or emissions avoided. You're getting actually data around how you're helping. So really my interest started back then and over time, as you've mentioned, the growth of that market's actually been quite significant and demand's been very strong. So that's really where the interest started. So from a an ESG dedicated type strategy, getting involved in specific securities that actually help with the solutions as opposed to just limit the downside is realistically where, where, um, the interest started in these types of securities.

Paul O'Connor:

Just going back to my definition of green bonds, can you explain how I defined it accurate or, um, what else can you add to giving us all a better understanding of of what they are?

George Bishay:

It was very close. Ultimately the term green bonds and climate bonds are interchangeable. So they're the types, same type of securities. They're basically securities that are issued to raise finance for climate related solutions. Importantly, the money borrowed is ring-fenced and can only be used for predetermined projects. Examples of those projects would be wind farms, solar parks, hydroelectricity projects or low carbon buildings, low carbon transport. Similarly, a social bond raises finance for initiatives that improve the social outcomes in the community. And then finally, sustainability bonds are a combination of green and social.

Paul O'Connor:

So how big is the green bond market in Australia and who issues these securities and is there any concentration of issuance in a certain industry or sector or is sector issuance also broadening with, uh, just the more general broader increasing issuance of green bonds globally?

George Bishay:

The size of the market in Australia is $54 billion, which sounds like a large number, but it's only about 4% of the Australian bond index in Australia. So it's actually quite small relative to the market, but it's a large outright number. So this includes green bonds. They make up about 30 billion of that, uh, 54 billion. 10 billion is social bonds and sustainability bonds are 15 billion. Now in relation to the diversification question, we're absolutely over the last bunch of years seen an increase in diversification of issuance across sectors and across issuers. So if we look at our market today, there's about 10 different sectors uh, within the fixed income market that issue green bonds. There's 40 different issuers and there's about 80 individual securities. So we think about the sectors, we've got the likes of domestic banks, so for example, Commonwealth Bank, we've got offshore banks, we've got universities, industrials, the likes of West farmers and Woolworths real estate such as G P T, Lendlease, telcos, utilities, sovereign agencies, semi governments and commonwealth government back there is a lot of diversification and that's only been increasing over the last few years, which actually provides a good foundation for a diversified portfolio in these specific asset class or securities.

Paul O'Connor:

And I'd suggest that over time there's gonna be more and more issuers coming to the market with these, these securities. Yeah, Well I guess it surprises me a little there, George, when you said it, it really covers the whole gamut of the fixed interest universe, the investment grade. Yes. Fixed interest universe with BBS and semis and then credit. So it obviously gives you a fair opportunity to diversify a portfolio when you're building the portfolios and the funds you

George Bishay:

Manage. Yes, it does. Just specifically on the govs, it's not the Commonwealth government issuing these bonds. It's actually a Commonwealth government agency and it's got the Commonwealth government guaranteed issuing, it's called National Housing Finance Investment Corps. So they're actually social housing is this specific issuer. So we've been engaging a lot with the sovereign in the hope that they will issue a, a green bond at some point under the previous government. That was highly unlikely under the new uh, government. It's likely, but I'm not sure whether that happens, uh, this year or next year. But we're hoping to see one in the not too distant future. 

Paul O'Connor:

Why would you invest in these types of bonds?

George Bishay:

There's two main reasons. Firstly, if you want your investment to do good and support climate stability or support the underprivileged in society, these are absolutely the securities to invest in. They help transform old carbon intensive infrastructure to environmentally friendly practises. So ultimately, if you wanna invest to do good, these are the securities. And the second thing why you'd invest in them is actually a tailwind in relation to performance of these securities as well. Because demand is so much stronger than supply when these new bonds are issued, they perform very well in the secondary market.

Paul O'Connor:

What's the credit risk of green bonds? And for example, what happens if a solar farm defaults? Are there any rights to the solar farm assets to protect the bond holder?

George Bishay:

Yeah, that's a really interesting question. The credit risk for these securities is linked to the issuing entity, not the underlying projects. So the way they work is the money's raised. I'll give you an example. Commonwealth Bank, when they come and do a green bond, the money is raised, the money's ring-fenced and can only be used for predetermined projects, let's call them wind farm solar parks. If there's a default on a specific wind farm or a solar park, it actually doesn't impact our security 'cause our credit risk is facing CBAs entire balance sheet CBAs credit quality, not the individual loans. So what happens is if there is an underlying default of, say one of the, the projects that project tends to be taken out and a new wind farm come back in. So it doesn't really impact the credit quality of our securities 'cause we are facing CBAs balance sheet.

This is a really important point because we are facing CBAs balance sheet. The security has a high credit quality. However, if we were facing the individual projects, the credit quality will be very low and therefore the liquidity in those securities would be very tight, very difficult, and maybe no liquidity at all. But by facing CBAs balance sheet and the credit quality on these securities being quite high, it allows for secondary market activity and allows us to have these portfolios that can buy and sell these bonds in the secondary market to deal with basically the, the flows that we get, whether it's an application of redemption in our fund. So ultimately the credit risk is for the, to the issuer, not to the underlying projects.

Paul O'Connor:

That's a very interesting point you make there, George, that whilst the capital raised is ring-fenced on what it can be spent on the actual credit risk to the investor, there's simply the entity that's issuing it, which I guess there's no different to any other security in fixed interest ignoring asset backed securities. Of course it makes sense there and the credit risk then is a lot lower I guess, than what a lot of people would have thought.

George Bishay:

Yes.

Paul O'Connor:

Can companies historically regarded as say a large polluter or producer of old energy actually issue green bonds? And how would you analyse and get comfort that a bond is genuinely a green bond? Is it all about the strength around the ring fencing of how the capital will be deployed?

George Bishay:

Yeah, again, that's a fantastic question. Pretty much any company or entity can issue a green bond assuming they have the underlying green assets to do that. So whether you are a, a big polluter or a small polluter, that doesn't really matter. Anyone can issue it. Now. However, that doesn't mean we invest in it. When we go through our process, we ensure that there's an alignment between the ESG credentials of the issuer and their climate vision as well as the underlying projects. So if you have a large polluter that is committed to reducing emissions in a quick way, stretch targets instead of not just business as usual, they're actually committing to reduce emissions as quickly as possible. We would absolutely look at the green bonds from that specific issuer. However, if you've got a large polluter who doesn't really care about the climate, doesn't really have any commitments to reduce emissions in a stretched way, we would not look at that, that green bond from that issuer.

So ultimately it's really important for us that there is an alignment between the issuers EGS credentials and climate vision as well as the project. So ultimately we don't invest in every bond, every green bond that comes to the market, we may invest in one in every third bond that comes to the market, whether it's related to credit quality, not happy with ESG, credentials of the issuer or the valuation of the security. So it's really important to not only look at the underlying projects, but to look at the, the vision of the entity itself that's issuing,

Paul O'Connor:

How clear is it that the underlying projects are actually green or ESG is, is can that be a, a quite a complex area of analysis for, for you and your analysts?

George Bishay:

Yeah, for sure. We do a huge deep dive into obviously not, not only the issuer but a deep dive into the projects as well and looking at are these the type of projects that we want to be involved in? Uh, what are the risks around these projects? How much are they actually gonna contribute? We have a huge impact database that collects information pretty much on every bond in the market and therefore when a new issue comes, we know what we can expect from specific types of projects, things like that. Importantly for us, we only invest in securities where there's a process around managing the projects and the proceeds as well as an external third party auditor. And finally the issuer has to commit to producing an impact report that basically provides the actual impact of the bond proceeds. Example would be renewable energy generated, these types of things. So with that sort of third party auditing process, it does give us confidence in, in the fact that the information that we're giving from the issuer, uh, is actually accurate.

Paul O'Connor:

And I guess from your comments there, it sounds to me that it would be very difficult to run a passive green bond strategy then given the uh, analysis of the actual project that the money is going into the yearly impact report, et cetera. There would, do you think that'd be a fair comment?

George Bishay:

I think we're really focused on ensuring that what we invest in is true to label and we have a very high threshold as to what makes that a green bond or a social bond worth worthwhile. Because ultimately our investors want to know what we invest in and we wanna eliminate any concept of greenwashing in in our process. So a passive and there are, uh, funds like that in Australia where they basically invest in all green bonds. For us, it is way more important for us to ensure that the securities that we're investing in are high quality impact securities as opposed to something that looks a little bit like business as usual and has basically named Green Bond when realistically we would wouldn't view it as a green bond. We just view it as business as usual.

Paul O'Connor:

You've touched on ring fencing, the use of the capital. So what evidence is there that all capital raised from these investments goes into ESG projects and are they actually doing any

George Bishay:

Good? Absolutely. This sort of touches a little bit on what I was just chatting about just a minute ago. It's around this concept of this third party auditing that occurs 'cause we're not going into the 80 different securities going into the company books and checking that the money's there. We're relying on third party auditors to give the sign of approval and a tick to say, absolutely the money only went to X, Y, and Z. And it basically gives us a level of confidence that the securities that we invest in are actually doing exactly what they said they would. So realistically, this concept of the third party auditor plus the impact reporting, which is ultimately a report that comes out that actually talks about the positive impact that you're having with the actual data that gives us sort of the confidence around that these projects are doing exactly what they're supposed to be doing.

Paul O'Connor:

Yeah, it's interesting the impact report you've mentioned a couple of times there. So I guess at the end of the day that shows you definitively if it's actually doing any good, the investment and what sort of, I guess, progress the companies are making at building out a, a solar farm or wind farm or something of that nature. Yeah, absolutely. We've touched on greenwashing and and that's prevalent. Um, and we hear a lot about it at the moment in the media and the regulator, and I think ASIC's been quite strong in this area. So have you got any other co more broad comments about how you manage this risk? You've, you've spoken about the yearly impact report, the way you try and look at and understand the project that it's genuinely green, but any other comments you would make in this area?

George Bishay:

So greenwashing is basically a practise of overstating or misleading investors in relation to either the environmental credentials of the company or the green bond. The way we manage this initially is analysing the issuer first, the ESG credentials of the issuer, the climate vision that they have. And then we go to the underlying projects and have a look at those projects and do the deep dive there. And a part of what we do before we invest in any of these securities is huge amount of ESG, engagement in relation that we're very comfortable with this concept of alignment of the projects and the issuers climate vision because ultimately we know what to expect. We don't invest in any labelled green bond just because it's a labelled green bond. We're very discerning in what we invest in. So from our perspective, when we're looking at a project, we wanna make sure that it's actually doing something beyond business as usual. 'cause if it's a business as usual practise, that to us is a vanilla bond. That's not a green bond from our perspective. It's very much are they actually contributing or supporting climate stability, uh, via renewable energies or reducing emissions. For a couple examples there,

Paul O'Connor:

Can green bonds be a core defensive allocation in a portfolio and do they generate the same yields as like as similar bonds in the border universe? Or do investors actually give up some return and I guess because of the social outcome or the social return that these investments are generating?

George Bishay:

Yeah, absolutely. Green bonds can be a core allocation in your portfolio. The returns of green bonds primarily follow the returns of the vanilla bonds from the same issuer. So if you've got company X issuing a green bond and also issuing a generic bond, the return profile very high level will be reasonably similar. However, there's this concept of a green attached to green bonds. When I say greenham, either the price is slightly higher when you're buying it, so a little bit more expensive or the yield is slightly lower, it is marginal, it's not significant, it's just slightly, however, where you benefit as a green bond holder because you could say, well, I'm paying a bit more for it, is what happens in the secondary market. The demand for these securities is far stronger than the supply. So if we think about new deals coming to the market, they're anywhere between two times oversubscribed up to eight times oversubscribed, how much they're issuing. You can imagine in that scenario how they perform in the secondary market. So even though there's a slight green attached to these, the secondary market performance absolutely compensates you for that.

Paul O'Connor:

So effectively I, my take from that is that you can actually sell the bonds in the secondary market for a capital gain. Correct. I guess the other positive, uh, point you've made there is that if, uh, you're a corporate or an entity wanting to partake in the whole green area solar panelling or what have you, there's no shortage of capital that you can raise if the project actually stacks up, obviously.

George Bishay:

Exactly. And there's this, this halo effect for issuers who issue a green bond. So if you've got a listed asex company issuing a green or a social bond, what tends to happen is their company then promotes to the world that they're issuing these securities. And what happens is the equity investors give that issuer a tick of approval from an e s G perspective, which ultimately can support their equity price in a weird way. So there's actually this halo effect for issuers issuing green bonds. So that's why I, or social bonds or sustainability bonds, that's why I envisage that issuance across many issuers will happen down the track.

To me, it makes sense that the, the equity piece could also get a benefit out of it given that you, I guess it's giving an indication to the market about the longer term focus and direction of the corporate and that it'll be a sustainable entity and it won't be stuck in an old energy business or what have you there. So no, very interesting. George Equity ESG portfolios underperform, for example, when oil prices rally given that these funds will screen out fossil fuels do fixed interest, ESG portfolios also underperform when oil or perhaps any other old energy commodity rallies.

So ESG fixed income portfolios also screen out fossil fuel companies. However, the important point for Australian bond market is oil related or fossil fuel company related entities are a very, very small exposure or percent of the bond index in Australia. Now that's different in the US where there's actually quite a decent size exposure of fossil fuel companies in the US bond market, but in Australia it's actually very small. So if you're thinking about what a return of a vanilla bond fund will look like versus an ESG bond fund in Australia, and if you specifically focus on the fossil fuel screens, it should be marginally, if anything, because ultimately it doesn't have a big impact on, on the market in Australia where the ESG funds tend to do well versus a vanilla fund is the fact that they don't invest in companies that have e significant E S G risks that the market's not really pricing in. So that's why ESG funds tend to do well relative to vanilla funds via this concept of a, of a focus on ESG, uh, above and beyond what a vanilla fund would.

Paul O'Connor:

So can you explain to listeners how this market's developed and what's been the biggest improvement you've seen over the years? And, uh, it's probably fair to say, George, you'd be one of the most experienced people in, uh, ESG fixed interest management

George Bishay:

In Australia. Yeah, that's a fair, fair comment. I, I, that's probably the case. There's two main developments that we've seen. One is, as we spoke about a bit earlier, is a diversification across sectors and issuers that are in our market now relative to prior years. So that's been a fantastic development. The second development is this concept of a sustainably linked bond. I think they've been around now for a year or two in Australia. Now, the difference between a sustainably linked bond and a green bond is the green bond. We've discussed the money's ring-fenced only used for predetermined projects. It does not go to general corporate activity. The sustainably linked bonds though, are different in that the money does go to general corporate activity. However, the company or the issuer commits to predetermined targets. So for instance, they may commit to reducing their emission footprint significantly within a short period of time.

So that's the difference. The money, it's not being fenced for specific projects, the money's going to general corporate activity, but they have this commitment to reduce, for argument's sake, uh, emissions stretch target and above and beyond business as usual. Now, the important point here is these targets are important because firstly, they have to be stretched because they, they can't be business as usual, otherwise they're just a vanilla bond. And secondly, if the company or entity misses its target, they are penalised by paying a greater interest bill on their bonds. So it's very important for the issuer twofold to hit those targets. Firstly, they don't wanna pay additional interest coupon, and secondly, they don't want their name effectively trashed in the ESG world by them basically overcommitting, but under a, delivering from their, uh, their commitments. So the important point about the sustainably linked bonds is, or it's twofold, it's very important that the targets are stretched. We don't want them to look just like a vanilla bond. And secondly, every entity in the globe effectively can raise money via sustainably linked bonds, via commitments to whether it's climate solutions or, or social, uh, support if it's socially supporting the underprivileged. Whereas not every entity on the planet can issue a green bond 'cause they don't necessarily have the specific underlying projects. So this concept of sustainability linked bond actually opens the gamut of issuers to issuing ESG bonds globally. You

Paul O'Connor:

Mentioned social bonds. Can social bonds also generate a financial return that's commensurate with the broader universe?

George Bishay:

There's two types of social bonds. One is a bond where the return profile of the security is linked to the out social outcomes. And if the social outcomes miss the return profile of the bond falls, now we don't invest in those specific securities. We wouldn't really call them bond securities, we would call them alternative assets. The securities that we invest in where the return profile is basically fixed, as in, you know, what the return profile's gonna be, it's either a coupon or a floating rate bond and the credit quality is linked to the issuer. So from a social bond perspective, it's no different to a green bond in that you receive your coupons from the issuer, the credit risk is to the issuer, but ultimately the underlying projects are to support the underprivileged in society. So we basically view them the same as a green bond and a social bond, obviously targeting different types of support, whether it's climate stability or, or the underprivileged in society.

Paul O'Connor:

Maybe just to finish with George, what do you think will be the biggest issues going forward with ESG or green bonds?

George Bishay:

The biggest issue right now, and it's become very prominent over the last six months to 12 months is regulation. So as you mentioned at the start, greenwashing is absolutely a focus from the regulators, and it's basically to ensure that products are true to label. In Europe, they've got this concept of Article eight and Article nine funds. Article eight is where a portfolio is specifically an ESG portfolio. And ESG integration is a standard in what it does. And then article nine are those funds that specifically have sustainable goals as one of their objectives. So it has to be a part of their objective. Now, I could see this happening here at some point in the future. I guess what that does is it makes it harder for, uh, bonds or fund managers to fudge the impact they're having. We actually welcome all of this, uh, given how discerning we are about what we invest in, more regulation, more reporting can only be a benefit and it actually safeguards the industry. And it's actually one of our goals with our engagement efforts is to minimise greenwashing and ensure the industry stays, stays true to label. So, so we, we actually, um, are looking forward to greater regulation in in in this space.

Paul O'Connor:

Yes, George. Well, thank you very much for joining us this morning on the Netwealth Portfolio Construction podcast. So it's been fascinating and very educative to hear about, I guess the whole growth of the green bond universe, the investment opportunities set, uh, for investors, and certainly positive to hear your comments about the way corporates are actually ensuring that the money's ring-fenced and genuinely going into projects that are considered green. And I've always been of the view that the, the longevity of a company is directly linked to, I guess, the way it adheres to society's standards. And I find that the whole growth of ESG really puts a, a, a strong focus and spotlight on the corporate and ensuring that it's a, a good corporate citizen ultimately there. And we're actually generating an improved standard of living, which is what I think stock markets exist for and capital markets more broadly there. So thanking you for your comments there, and also very positive to hear that it does certainly sound like that green bonds can be a core part of a strategic asset allocation in a portfolio. They're a long-term investment and they're not, um, I guess a, um, a shorter term tactical play that we see a lot of those types of strategies in the market. So again, thank you George, and I've been very appreciative of the time and your comments this morning.

George Bishay:

Thank you for having me. Well, one, one point I might just leave you with that I've noticed over the last three years is the fact that people are using my dedicated ESG strategies now as a core fixed income hold, whereas previously call the fivefold. Years ago, the ESG funds specifically sat in their ESG sleeve of their balance fund. Now they're actually using my portfolios as their core fixing

As an alpha kicker. Um, give, yeah, giving your comments about the secondary market pricing.

Paul O'Connor:

Yeah. Performance has been, fortunately has been quite good, but ultimately that, that's the most interesting thing that I've seen over the years is that people are loving these specific bonds and the fact that we are reporting them a certain way and they know the impact they're having, as well as the fact that our performance has been pretty good. 

George Bishay:

Years. And it certainly makes sense also given your comments about the credit risk, that at the end of the day, it's simply the credit risk of the issuer. It's not the underlying project there, which yes, may or may not be wasier than a, a broader correct, uh, Capital, and it's the issuers we're investing in anyway, so, yeah. 

Paul O'Connor:

No. So, uh, thank you very much again, George for, uh, for joining us today and certainly to the listeners, I hope you, uh, you've enjoyed this morning's discussion with George Bishay from Pendal Group on the ESG or the whole development of the Green Bond universe. And hope you have a great day and I'll look forward to you joining us on the next instalment of the Netwealth Portfolio Construction Podcast series.

George Bishay:

Great. Thanks Paul. And, and looking forward to listening myself. Thank you.

Paul O'Connor:

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