How have AT1s traded this week
Over the past 12 months the ESG world has been dominated by ever-changing regulation and reporting requirements, both of which still remain unknown in terms of their end point.
An important ‘known’ development this year was the details from the ECB on their plan to ‘green’ their asset purchasing program going forward. For market participants, the events of the last 3 years have reinforced how important the actions of central bank purchases have been for credit spreads, and so a shift in the eligibility criteria is something fixed-income investors cannot ignore.
To recap, the ECB began their Quantitative Tightening program this month (March) in which the full value of maturing securities from their APP (Asset Purchase Program) will not be reinvested, allowing the balance sheet to shrink by €15bn per month. Principal payments in excess of €15bn will be reinvested across the different programs of the APP which features a corporate bond purchasing program as well as an asset-backed securities and covered bond purchasing program.
To green the portfolio, reinvestments will be phased out of the primary market with the exception of ‘non-bank corporate issuers with a better climate performance and green corporate bonds’ while secondary purchases will be more strongly tilted towards issuers with ‘better climate performance’. In doing so the ECB note these plans will ‘support the gradual decarbonisation of the Eurosystem’s corporate bond holdings, in line with the goals of the Paris Agreement’. However how exactly the ECB defines issuers with ‘better climate performance’ remains open to interpretation; for example they do not rely on third-party scoring and have their own internal climate score for each issuer which they do not disclose.
In order to align with the goals of the Paris Agreement the ECB plan to increase the average climate score of the portfolio over time and have published the details of the three key scoring pillars which determine the overall issuer score:
1. Emissions sub-score - how do current emissions rank against peers, best in class, etc. (backward-looking)
2. Target sub-score - how credible and ambitious are forward-looking emission reduction targets;
3. Disclosure sub-score - whether these interim and long term targets have been verified or not, referring to Science Based Targets initiative (SBTi) status or similar.
Broadly speaking, these pillars match the theme we and other investors have followed for the past five years, namely, pushing for transparency on raw emissions numbers, then net zero targets, and more recently the verification of such targets. Going forward, we think the verification of targets will be particularly important as it determines the credibility of management’s environmental plans. Issuers that lack data are given the lowest climate score for that pillar which should aggressively encourage issuers lagging to ramp up net zero efforts or get left behind. Having said that, we would encourage the ECB to put even greater weight on the second and third forward-looking pillars as we believe these will have the greatest long term impact.
Credit where it’s due though, overall we think the message is quite clear from their scoring model – formulate credible net zero targets and get them verified.
Away from scoring, the ECB made it clear they will remain active in the primary market but only for green bonds or issuers with ‘better climate performance’. This further supports the strong demand YTD for green bonds and we can expect primary oversubscription levels to persist. In February, the average oversubscription level for ESG labelled deals was 4x versus 2.8x for non-ESG issuance, according to data from Santander. Issuers with the ability to issue under the green label will seek to capitalise on this technical and capture the ‘greenium’ (the spread differential between a green bond and the equivalent vanilla bond) which varies by issuer but is around 5bps on average.
Green bonds remain the preferred choice for issuers and represented 63% of ESG labelled supply in February, with sustainable and social bonds representing 22% and 15% respectively. The positive technical from the ECB is expected to drive this number higher and in doing so could well further increase the 5bp ‘greenium’. Indeed recent data from BAML supports this view, ‘in October-January bond purchases, the ECB bought mainly new issues, including about 68% of newly issued green bonds’ which is an incredibly strong tailwind for secondary performance. However, given many issuers that have credible environmental plans do not have the vast pool of assets or projects to issue under the green label, we would encourage the ECB to expand their primary purchases to include other ESG labels such as sustainability-linked bonds.
Away from the ECB, ESG fund flows are also an incredibly strong technical for ESG assets. According to data also from Santander, in February European fixed-income ESG funds recorded $2bn of inflows which marked the fifth consecutive month of inflows. YTD European ESG fixed-income inflows stand at $5.6bn which represents 29% of all inflows into European fixed-income funds. There is clearly a significant amount of money flowing into ESG funds and although in our opinion they tend to be more immune to broader macro volatility compared to conventional fund flows, this trend further supports the positive technical driving valuations.
Time will tell what the ECB’s ‘greening’ really means for credit spreads. With monetary policy now tightening and balance sheets shrinking, central bank actions will impact spreads but maybe to a lesser extent when compared to a QE environment. However, one thing is certain, the direction of travel is very clear when you combine fund flows from the investor community and the actions of the ECB. Ultimately, there is too much money chasing too few assets which creates an incredibly strong technical driving valuations and makes the case for further dispersion between assets eligible for the ECB buying and ESG funds, and those that aren’t.