The sustainable debt market has become unsustainable

The European Union has offered its first social bond — as in the middle initial of ESG: environmental, social, and governance — in a two-part, 17 billion euro ($20.2 billion) sale. Investors were ravenous. When all was said and done, the offering was oversubscribed 14 times over. Orders blew past 233 billion euros, making it likely the biggest debt sale ever. It’s easily double the previous record demand of 108 billion euros for Italian debt in June.

There are a number of reasons EU’s social bond was in such high demand. For one, it carries the bloc’s AAA credit rating. It’s also the EU’s first joint debt offering since the bloc agreed to its pandemic recovery deal. The fact that it’s a social bond — the fastest-growing segment of sustainable debt, the asset class that also includes the trillion-dollar green bond market — is important. How is it important? Well, it’s complicated.

It’s certainly not a bad sign for sustainable finance that demand for a AAA-rated social bond exceeds supply by more than an order of magnitude. Nor is it bad for the bond issuer — demand well in excess of supply will bid prices up, resulting in a lower yield. It also gives new issuers significant incentive to offer their own sustainable debt, be they companies, supranational organizations such as the World Bank, or sovereign entities.

Bloomberg

But we wouldn’t call this runaway demand a good sign, necessarily, either. A seller’s expensive price also runs the risk of being a buyer’s too-high price, for instance. A sustainable debt premium could actually price out some asset managers, who (rightly) have a mandate to seek the best bond fund performance for asset owners.

A 14-times-oversubscribed sustainable debt offering also indicates a market that’s structurally underserved. In theory, the EU could have sold not 17 billion euros of AAA-rated social bonds, but rather 200 billion. This, to me, is an unsustainably low supply of sustainable debt. It creates the possibility that buyers will take their debt appetites elsewhere, no matter how green or sustainable their intentions.

Sustainable debt issuance exceeded $560 billion last year, and has already reached $460 billion and beyond in 2020. The EU’s social bond sale indicates there’s sufficient demand for a market multiple times bigger than that. If the market becomes 10 times larger, we should look for it to replicate the instruments of the existing debt market—and that means securitization.

Right now, almost all sustainable debt is B-rated or higher, meaning that its issuers are generally seen as low credit risks. At much greater scale, though, we should expect to see a wider range of credit ratings. If that happens, there’s the potential for sustainable collateralized loan obligations — “bundles of speculative-grade loans, sliced into different tranches, with the lower-rated portions suffering the first losses to protect payments to those invested in the top layer,” as Bloomberg’s Brian Chappatta describes them. ESG-themed CLOs already exist, though their “green” qualities are largely at the arranger’s discretion; there’s no regulation setting specific criteria, and volumes are quite small.

A much bigger market might give some investors pause, as over-securitization was a major part of the 2008-9 global financial crisis. But if it’s part of achieving the five- or 10-times greater scale that sustainable debt buyers are seeking, then a little speculation could be … well, sustainable.