Banks are the main issuers of Green, Social, and Sustainability (GSS) bonds, representing nearly a third of this $1.2 trillion market (Figure 1). But over half of banks’ GSS bonds are either subordinated, as senior non-preferred or holding company (“HoldCo”) senior unsecured debt, or consist of capital instruments, such as Tier 2 capital (“T2”) and Additional Tier 1 capital (“AT1”).
Banks mostly issue such subordinated bonds at the behest of regulators, and they can write them off in a crisis. That dilutes the argument that these bonds’ proceeds will be used for green or social purposes. We see three reasons why investors should treat such bonds’ claims to ESG eligibility with skepticism—see the conclusion for example results of our green bonds analysis.
Figure 1: Green, Social, and Sustainability bonds by sector in the Bloomberg Barclays Global Corporate Index (%)
Source: Bloomberg, as of 12 February 2023
GSS bonds issued for the purpose of regulatory requirements
Issuers of GSS bonds commit to investing their proceeds in projects or assets considered beneficial to the environment or society. In the banking sector, eligible uses of proceeds include loans to renewable energy projects, mortgages on sustainable houses, SME (small and medium-sized enterprise) loans, education or healthcare loans etc.
Yet, several banks have issued capital instruments, senior non-preferred, or senior HoldCo bonds (senior bail-in debt of this kind is intended for the bank to meet additional requirements on loss-absorbing capital) in the form of green or social bonds.
Some market participants argue that issuing green solvency capital and loss-absorbing debt shows commitment to ESG. In their eyes, doing so indicates willingness to have a green component in the permanent capital structure of the institution, rather than simply using it for operational, day-to-day funding.
We strongly disagree. In our view, the issuance of solvency capital instruments and, to a lesser extent, senior bail-in debt with green labels is more often than not misleading for investors for three reasons:
1. Banks use GSS bonds to support non-GSS assets.
2. If GSS bonds are bailed in, the equity capital they provide can finance non-GSS assets.
3. GSS bond maturities may not match the maturities of GSS assets.
1. Banks use GSS bonds to support non-GSS assets
Originally, banks issued green bonds as senior unsecured funding instruments: a €250 million bond issue would allow a bank to provide €250 million of qualifying green or social loans.
However, solvency and loss-absorbing debt does more than provide cash to be lent on: its primary purpose is to meet regulatory requirements. Such requirements apply to the whole bank, not just a green sub-section.
Most banks are subject to capital requirements expressed as a ratio of capital to risk-weighted assets (“RWA”)— a measure that adjusts loans and other assets for their relative credit risk with riskier assets receiving a higher weighting.
For example, if a bank had a T2 capital requirement of 2% and risk-weighted assets of €10 billion, its total T2 capital need would be €200 million. Issuing a €250 million T2 bond would more than cover the bank’s entire need for regulatory capital—well in excess of the funding provided by the bond.
But issuing this T2 bond as a green bond is misleading, because the benefit to the bank is much wider than the €250 million allocated to the green bond pool. For this green bond to be credible, the bank’s entire €10 billion risk-weighted asset base—including all of its loans—would have to be green or social.
Put another way, every euro of T2 capital that investors lend to the bank facilitates more than one euro of lending—not all of which is green.
2. If GSS bonds are bailed in, the equity capital they provide can finance non-GSS assets
Solvency capital and bail-in debt are designed to absorb losses and recapitalize banks without interrupting their normal course of business. This raises questions about the credibility of a green bond explicitly linked to a particular pool of assets.
The criteria used to trigger bank bond write-downs are based on group-level factors. Regulators have been clear that there must be no link between the performance of eligible assets and the capital functions of the bond raised to finance those assets.
In other words, if losses in the bank were large enough to trigger a write-down, the GSS bonds would also be written down, even if the GSS asset portfolio was performing well. This risk appears well understood by most GSS bond investors, but we view it as at odds with the principle of a use-of-proceeds bond.
To add insult to injury, in case of a green bond write-down, bondholders might be left holding equity in the bank. Equity, by its nature, isn’t applied to one, ring-fenced part of a company. As a result, GSS bond investors would own a share of non-eligible assets not even loosely linked to the original, eligible portfolio of green or social assets.
3. GSS bond maturities may not match the maturities of GSS assets
AT1 and T2 bonds are typically callable as increasingly are senior bail-in instruments. So, the maturity profile of GSS capital instruments is very different from other GSS bonds issued by banks, which typically have maturities between 5 and 7 years (Figure 2).
Figure 2: Average maturity at issuance of bank GSS bonds (years)
Source: Bloomberg, as of 15 February 2023.
Most capital instruments are issued with the expectation that they will be called at the first opportunity. However, if spreads widen significantly, issuers may choose not to call, for example because the cost of refinancing the outstanding bond is too high (A Fresh Approach to Analyzing Bank Capital Bonds). This is known as extension risk and introduces uncertainty around the eligible portfolio.
The eligible asset pool may contain assets of sufficient maturity to fulfil the criteria over the life of a 5-year bond but not over a 10-year period.
Investors need to assess the risk that an unexpected extension leads to possible future breaches of terms.
Conclusion: how does our approach affect our management of ESG portfolios?
At PGIM Fixed Income, we assign ESG Impact Ratings at the issuer level, which represent the total impact that the issuer has on the environment and society. However, we can uplift those ratings for individual or program GSS issues that we deem especially impactful. We do so by scoring use-of-proceeds bonds on their credibility and on the additionality of their proceeds to improving the environment or society.
Based on the concerns we outlined, our base case assumption for bank solvency and bail-in senior capital is that neither has sufficient credibility. Sometimes, we give limited credit for additionality, including exceptions for bail-in bonds (rather than capital instruments) with particularly positive eligible assets. Swiss banks, for example, only issue green bonds as senior non-bail-in debt, albeit primarily at the behest of the regulator.
Figure 3 shows our credibility and additionality assessments for selected bonds. The purely regulatory instruments of banks A and B receive a low credibility score. But the senior preferred debt of Banks C and D receives different credibility scores, based on whether that debt is primarily used for funding or regulatory purposes.
Figure 3: Some Green Bonds Have More ESG Impact than Others
Source: PGIM Fixed Income. For illustrative purposes only. The above is not inclusive of all ESG potential issues and engagement. ESG ratings are subject to change without notice. Please see the Notice for additional disclosures.
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Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of February 28, 2023
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