Russian military action in Ukraine and associated volatility in global markets is questioning assumptions around the extent and timing of expected monetary policy tightening in major economies, as central banks also commence the unwinding of massive quantitative easing programs.
With inflation surging, the rationale for an increase in historically low interest rates in many countries remains. The UK has already raised rates and a rapid succession of hikes is forecast in the US. CBA’s economics team maintains its expectation of a first increase in the Australian cash rate by the Reserve Bank of Australia (RBA) in June this year.
These significant dynamics are playing out in capital markets and will undoubtedly alter the cost of funding, with credit spreads already widening materially and yields trending higher. The ending of the RBA’s Term Funding Facility for banks is another contributory factor placing upward pressure on funding costs.
Access to capital is a critical component of achieving the global task of transitioning to a low carbon economy. Currently there is an estimated $85 trillion in global non-financial corporate debt outstanding according to Bank for International Settlements data and the cost of servicing this debt is going up over time. Could this siphon money away from the critical investment needed to support the transition to net zero?
Our view is that the sustainable finance market is now an embedded focus for both borrowers and investors, and that over time it will likely become indivisible from mainstream finance. There is an evolving understanding that the transition must be financed and that harder transition stories can be supported, providing the issuer commitment is genuine. Investors want to see transition plans that can deliver significant impact and are achievable, given their accountability to unit holders.
Globally the sustainable finance market has grown 10 times since 2016 and increased by up to three times in size last year alone – driven by the sustainability-led agendas of issuers and the growth of ESG mandates among institutional investors. Issuers are also further incentivised to issue in an ESG labelled format given the emerging ‘greenium’ or premium in capital markets, reflecting the high demand from investors for issuers with strong sustainability credentials.
BloombergNEF data shows that more than $1.6 trillion in sustainable debt instruments were issued globally in 2021, bringing the total outstanding market to over $4 trillion. In Australia, sustainable bond issuance grew from circa $12 billion in 2019 to around $20 billion last year, totalling around $50 billion of sustainable bonds outstanding in the domestic market – around 2% of the total bond market in Australia. We estimate the Australian sustainable bond market has the potential to grow to $350 billion over the next decade to support our transition targets.
Given this level of supply and changing market dynamics, we see a ‘first mover’ advantage for issuers in a position to access the market sooner. Current market volatility may actually speed up the pace of transition even further, with increased funding costs, rising carbon prices and reputational concerns front of mind for issuers who have yet to develop and implement funding strategies for their transition. Currently, we see the pool of capital targeting ESG investment as bigger than the supply of investable assets, but this will likely change as the volume of ESG debt issuance increases.
ESG investors are growing in sophistication and demands. While there is a spectrum of ESG investor profiles, ranging from those agnostic to ESG labels to ‘deep green’ impact-led investors, there has been a general shift in the understanding of ESG issues and how they can both threaten and present as an opportunity to investment portfolios. There is increased scrutiny around ESG labels, structures and products that are emerging in the market, which will only continue. Our expectation is that ESG bonds may outperform vanilla bonds in weaker markets, as investors with ESG specific mandates may be less likely inclined to sell these bonds.
The growth of private capital markets is another dynamic that will continue to evolve, particularly with the relative potential weakness in fixed income returns for investors. Private capital may offer a more efficient source of funding for corporates with particularly demanding ESG challenges or for industries negatively screened by public investors, creating investment opportunities which satisfy the usually higher yield threshold of private investors.
After a period of prolonged stability in global markets we are already seeing significant changes in capital markets in 2022 and anyone with funding or risk management requirements should be on the front foot for the volatility ahead.
This article was originally published in The Australian Financial Review (Nine Publishing) on 9th March 2022.
Chris McLachlan is Executive General Manager of Global Markets. In his role, he leads the Capital Markets, Fixed Income, Rates and Foreign Exchange business for the Commonwealth Bank.
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