European interest in social bonds growing

Asset owners in Europe are keen to deploy more capital into social bonds but say they are challenged by limited opportunities.

European investors' exposure to impact investments, particularly social bonds, has been growing in the last year — in part due to new rules under the European Union's Sustainable Finance Disclosure Regulation, which became effective in March. Under the rules, regulators are steering pension funds' investments into assets with a specific environmental, social and governance impact in addition to requiring them to incorporate ESG factors into all other allocations.

Social bonds issuance was $249.6 billion in 2020, up from $22 billion in 2019, according to figures provided by the Climate Bonds Initiative, an international organization that works to mobilize capital in the bond market to help mitigate the effects of climate change.

The new SFDR rules around impact investing, known as Article 9, have been useful to focus investors' attention on their contribution to the United Nations' sustainable development goals such as access to health care or workers' rights. These concerns were also elevated to the top of investors' agendas because of the coronavirus pandemic.

But while pension fund executives said they are keen on boosting their social bond investments, they admit that unearthing opportunities is not straightforward. Investors, which are currently largely dependent on bond issuance by institutions such as the World Bank or more recently the European Commission, are on the lookout for more investment vehicles that can help them achieve scalable allocations as well as measure and report on the impact of these investments under the SFDR regulations. It is not an easy task because the social bond market is underdeveloped and it lacks frameworks such as the Task Force on Climate-related Financial Disclosures, which can aid investors in measuring impact of their investments and communicating them to plan participants, sources said.

Since these standards don't yet exist, the social bonds market hasn't reached a stage where impacts can be measured and communicated to plan participants, said Luba Nikulina, global head of research at Willis Towers Watson PLC in London. "When you issue a social bond, how do you make sure that commitments that you are making ... are genuinely improving social issues … and (that) they don't have unintended consequences in certain geographies?" she said.

Though social bonds issuance exploded in the last year, part of the problem for investors is that the market is not diverse when it comes to issuers, said Kate Hollis, director, investments at Willis Towers Watson PLC in London.

The social bond market in terms of issuance was up last year, but more than half of that was issuance from supranational organizations, and issuance by government entities of China and France, she said. Climate Bond Initiative data for 2020 show that 47% of social bonds were issued by governments and government-backed entities and about 13% was issued by supranational organizations. About 37% was issued by corporations.

For more opportunities to develop, more corporations need to issue social bonds, Ms. Hollis said. Comparing the social bonds market to green bonds, she added that "for a long-time (the) green bond market was very heavily weighted to supranationals but now it's much more diverse." The green bonds market increased to just over $1 trillion in outstanding bonds in 2020 from $345 billion in 2017.

Investors that are looking to deploy money into social bonds this year agreed that issuer diversification is one of the obstacles that will determine if they can get to their targets.

For example, Lars Dreier Kristensen, director, hedging and treasury at ATP, Hilleroed, Denmark, said the 906.6 billion Danish kroner ($147.6 billion) pension fund plans to invest 50 billion Danish kroner across social bonds and sustainable bonds — including green bonds — this year. A specific allocation to social bonds was not disclosed. The allocation was created at the start of the year. But he said that the fund's ability to get to its target will depend on the market and the issuance.

Mr. Kristensen said that the motivation for launching a social bonds allocation was similar to launching green bond investments a few years ago. "We saw a market in a rapid expansion. We are a large investor, so it was natural to dip our toes in it. We have seen exactly the same thing with social bonds. They have picked up quite a lot especially in 2020," he said. ATP's green bond allocation is 30 billion kroner.

Another challenge for Mr. Kristensen is selecting the projects to invest in as fund executives have to study how bond proceeds are distributed by social bond issuers. "We are looking quite a lot into ... a broad range of underlying categories on social issues. That could be anything from water (scarcity) to fighting extreme poverty. We have been very focused on having close dialogue, active ownership with issuers to be assured what is behind the underlying projects," he said.

"We are trying to mimic the strategy we had for green bonds with impact reporting with the issuers and transparency of underlying project data. It's important that we continue to that way. Our path is not to compromise on these things," he added.

Mr. Kristensen added that ATP manages its social bonds investments in-house. For the same issuer and the same credit quality, ATP expects the same return regardless of whether the bond is labeled as "social" or not, he added.

Alecta Pensionsforsakring, Stockholm, which has a 18 billion Swedish kronor ($2.2 billion) allocation to social bonds, is also interested in expanding its portfolio to satisfy demand coming from its beneficiaries.

However, Alecta's CEO Magnus Billing thinks that social bond investment structures and projects available to institutional investors are not easily found.

"It's the supply side that is critical for us. We want to see a pipeline of opportunities with scale," he said in an email. "It must make a difference that we put capital into an investment vehicle. That has consequences on assets that are available to us for investing."

Mr. Billing said that Alecta has the same risk-adjusted return requirements for social bonds as for conventional bonds. Alecta will invest depending on the credit quality of the issuer and the liquidity risk.

"We are eager to find scalability to preserve efficiency. That (has) put some limitations for us to grow this portfolio," he added.

So far, Alecta, which has 900 billion Swedish kronor in assets, has focused on buying social bonds issued by development finance institutions such as the International Finance Corporation and the World Bank.

Mr. Billing said that Alecta has very few direct investments and wants to work with partners such as money managers and supranational organizations to invest in social bonds.

"We think that is a necessity for us going forward as we try to build this portfolio. We will not be able to have a knowledge of local conditions so would rely on partners with local knowledge and track record to address local risks," he said.

"We typically look for a framework that is aligned with (our) social bonds principles and that has gone through an external review by an independent party," Mr. Billing said.

Alecta then assesses the issuer from an ESG perspective before examining the specific bond, he said. Then executives evaluate the objective and what types of project or activities the bond is financing, he added.

In June, Alecta invested $100 million in a social bond aimed at promoting healthy living in emerging markets. The social bond, backed by the Swedish International Development Cooperation Agency, was issued by a company set up by impact investment manager responsAbility and will finance investments that improve access to health care and sanitation, enhance sustainable food production, provide access to finance and reduce pollution through renewable energy.

Investors in the Netherlands are also looking to build up social bond exposures. Oscar Jansen, expert portfolio manager credits at APG Asset Management, said the firm wants to grow its investments to contribute to the sustainable development goals.

APG is the in-house manager of €495.3 billion ($599.7 billion) ABP, Heerlen, the Netherlands.

"As a sustainable investor we have been active here and have been able to increase our allocation to social bonds and more than double the exposure compared to the previous year. We expect the market for social bonds to grow further which will allow us to increase our exposure as well," Mr. Jansen said. He declined to provide the size of the allocation.

APG evaluates issuers' use of proceeds using an internal framework. Currently, APG only invests in bonds issued by supranational organizations. Investments match the firm's risk and return criteria.