Impact bond market faces shake-up in 2023 | Insight Investment

• Issuance of impact bonds and sustainability-linked bonds declined in 2022, but remained robust overall, as we observed strong demand continuing to absorb supply.
• We expect a return to growth in issuance in 2023, driven by the policy push towards low-carbon energy projects and a broader stabilization in the market environment, which should give issuers confidence to bring existing project pipelines to market.
• Regulatory and investor focus on standardization and transparency across the market is likely to shape issuance trends, such as cost of issuance and external verification of impact bond frameworks, with emerging markets likely to be key beneficiaries.
• Impact bond ratings moving to extremes with a higher proportion of both best-in-class and worst-in-class issuance, possibly pointing to the emergence of a two-tier market in terms of bond frameworks.
• Use-of-proceeds bonds are likely to be the focus of demand rather than sustainability-linked debt, but growth is likely across both broad sectors of the market.

Impact bond issuance declined in 2022, but the stage is set for a return to growth

The market of green, social or other sustainability-labelled debt was not immune to the wider market conditions of 2022, with a noticeable slowdown in new issuance in the second half of the year, resulting in an overall fall year-on-year from record growth in 2021 from around $1.8 trillion to $1.5 trillion¹. Nonetheless, a number of corporate sectors and regions (particularly in Asia-Pacific) have continued to see issuance growth in 2022, thanks to enduring investor demand for these instruments versus consistent undersupply. Agencies and governments have also been supportive of issuance over the past year. 

We expect these trends to continue in 2023, with a return to year-on-year issuance growth, albeit with a growing focus on quality over quantity of holdings as a result of heightened regulatory and investor scrutiny, particularly in Europe. Our forecast points to strong growth in corporate issuance – particularly in North America and Asia Pacific – offsetting slower growth in issuance by financial institutions, agencies and government issuers in 2023.

In particular, the policy push towards rapid deployment of low-carbon energy in many regions in 2022 is expected to be supportive of renewed energy-focused corporate issuance in 2023 in key markets such as the US, EU and Japan. More broadly, we expect that a stabilization of market conditions and interest rate changes in 2023 will give issuers confidence to bring existing project pipelines to market in the first half of the year.

Figure 1: Insight expects sustainable debt issuance to regain momentum in 2023

Source: Insight Investment, Bloomberg Intelligence

Growing standardization and transparency are likely to shape the market

• Cost of issuance

We see some headwinds to growth in 2023, not least the wider regulatory push towards standardization and crackdown on greenwashing in many jurisdictions, which could drive up costs of issuance. Whilst historically, green mandates and undersupply of suitable instruments have shaped investor demand for impact bonds, we see growing signs of sensitivity to transparency and quality of reporting on bond proceeds. Instruments that can demonstrate alignment with the EU Green Bond Standard for example will gain market access amongst some investors, albeit with higher associated costs of structuring, issuance and ongoing reporting.

• External verification of impact bond frameworks

Whilst increasingly commonplace within European issuance, external verification remains less widely employed in other regions, particularly the USA and China. Nonetheless, we expect to see some convergence with European trends over 2023. Major US issuers of green bonds such as Berkshire Hathaway have recently begun to publish reports on allocation of proceeds from these instruments for the first time, indicating rising investor demand for transparency.

Similarly, the US dollar-denominated Chinese green bond market (which is dominated by state-owned financial institutions) is coming under growing pressure from overseas investors to improve transparency and reporting on allocation of proceeds. China published its national Green Bond Principles in July 2022, which are closely aligned with international standards such as the EU Green Bond Standard and aim to address a previously fragmented domestic market. Despite this, state-owned enterprises can allocate up to 50% of green bond proceeds to non-green activities.

• Emerging markets set to benefit

Emerging markets are likely to be key beneficiaries of market stabilization, standardization and renewed growth of the impact bond market owing to the range of environmental and social investment needs in such markets, and key sovereign issuers such as India are expected to issue green bonds in 2023.

Impact bonds may be moving towards a two-tier market in terms of frameworks

Insight’s in-house assessment of impact bonds shows that while the share of such instruments receiving a ‘dark green’ best-in-class rating has fallen in recent years, alongside an increase in ‘red’ ratings, the share of ‘light green’ ratings that meet Insight’s sustainability and disclosure requirements for such instruments has remained stable. This is despite a sharp increase in the variety of issuers bringing such instruments to market in recent years, across diverse sectors, geographies and sizes. Demand for green bonds has remained strong for many investors, but there are signs the market may be moving toward a two-tier system, with rising demand for frameworks meeting the highest standards of reporting and disclosure amongst some and demand for lower-cost, more limited frameworks amongst other investors.

Figure 2: Insight’s ratings of impact bonds show a fall in ‘best-in-class’

Source: Insight Investment

Demand is likely to focus on use-of-proceeds bonds rather than sustainability-linked debt

The push towards greater transparency and standardization should be supportive of use-of-proceeds structures (such as green bonds) at the expense of more flexible structures such as sustainability-linked bonds. The past year saw a fall in the popularity of sustainability-linked bonds, particularly amongst financial institutions, where their variable coupon structure is at odds with regulatory capital requirements in many jurisdictions. More broadly, there is growing concern around the underlying integrity of ESG outcomes from such instruments, particularly given typical incentives for meeting key performance indicator targets under such structures.

The use of sustainability-linked bonds for general use of proceeds appears to be increasingly at odds with investor and regulatory expectations for greater clarity and consistency of allocation of proceeds to environmental and social outcomes. Nonetheless, these instruments will still have a key role to play in channeling transition finance to ‘high impact’ activities that may be less suited to use of proceeds structures, and we expect growth in issuance amongst some corporate sectors alongside a similar push for standardization and transparency from market participants and regulators.