Does This CDO Come in Green? With ESG Everywhere, Buyers Beware

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(Bloomberg Markets) — It started with bonds. Now even collateralized debt obligations (CDOs) come in green. From the humble bank loan to a complex swap, there is virtually no corner of finance for which an ESG product hasn’t been created. Experts say investors should tread cautiously.

In less than a decade, ESG—a style of lending and investing that gives the same weight to environmental, social, and governance issues as to traditional metrics such as leverage and cash flows—has moved out of the wings and onto center stage. Wall Street has unleashed engineers and experts on structuring and marketing securities to offer a whole load of new financial products.

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HSBC Holdings and JPMorgan Chase have priced ESG cross-currency swaps, Goldman Sachs is experimenting with so-called green equities, and Deutsche Bank has created several green repurchase agreements. Barclays has offered green structured products to retail investors, Axa priced an ESG collateralized loan obligation, and Standard Chartered crafted an ESG capital-relief trade. There are green mortgage-backed securities and ESG labels on asset-backed commercial paper, synthetic CDOs, credit default swaps, and money market funds. Some bonds are even being labeled “blue” to show they support water-related causes such as ocean preservation or sustainable fishing.

The phenomenon has all the hallmarks of a Wall Street mania. But in this case the new products are supposed to go beyond enriching investors—and actually change the world for the better. Over the next three decades it will cost about $100 trillion to meet net-zero emissions goals, not to mention the funds needed to address other environmental and social problems. Can green finance make a real difference, or is it just misleading marketing hype, otherwise known as greenwashing?

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“ESG products, so long as the banks and fund managers selling them have comprehensive plans to lower the emissions of their portfolios in line with science, could be the final puzzle piece that helps shift the trillions necessary for the transition,” says Casey Harrell, senior strategist with environmental nonprofit the Sunrise Project. “Without such a plan, greenwashing is the inevitable outcome.”

The acid test is whether an ESG product meaningfully raises the cost of capital for polluters compared with more environmentally friendly entities, says Ulf Erlandsson, a former Barclays Plc credit derivatives analyst who now runs the Anthropocene Fixed Income Institute, a climate-finance think tank. “The plethora of ESG pitches with pictures of children dancing around wind turbines at sunset but without any fundamental analysis is highly indicative of ESG being oversold,” he says.

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The ESG market today, with its lack of standardization, is “caveat emptor,” adds Eila Kreivi, chief sustainable finance adviser at the European Investment Bank in Luxembourg. Kreivi, who’s been involved in structuring and setting criteria for green bonds for more than a decade, says to “be careful what you buy and make sure your first question is always ‘Explain what you mean by ESG.’ ”

To illustrate just how fa
r the craze has spread, here are descriptions of four surprising ESG products:

Capital-Relief Trades

In a capital-relief trade, a bank that’s originated a portfolio of loans finds an investor to assume the risk for the portfolio’s first losses. In exchange the investor can receive a double-digit percentage return. Such deals, also known as synthetic securitizations or significant risk transfer trades, allow banks to hold less capital to cushion themselves against losses because they’ve transferred the risk to the investor.

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In December, Standard Chartered Plc structured its first ESG capital-relief trade. In the deal, known as Future Ready Chakra, the bank sold $90 million of credit-linked notes that will absorb the first losses on a $1 billion loan portfolio. The deal got the ESG label because the portfolio “was created to generate lending capacity in sectors which are required to support the transition” and includes loans to green hydrogen, carbon-capture utilization and storage projects, and green commercial real estate, says Anna Olsen, a member of the bank’s credit and portfolio management team. Olsen declined to provide details on the specific loans in the portfolio or the yields they offer investors.

Denver-based ArrowMark Partners, which has invested $5.3 billion in 73 capital-relief deals since 2010, bought approximately 30% of the first-loss tranche of the Future Ready Chakra deal, says Kaelyn Abrell, a partner and portfolio manager. She declined to ­disclose the investment return on the deal, saying only that “the transaction aligned with our objectives for investments in the asset class.”

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ESG deals can be less financially rewarding for investors than non-ESG transactions, says Olivier Renault, who spent more than a decade at Citigroup Inc. originating and structuring significant risk-transfer deals and now runs risk-sharing strategy at private credit firm Pemberton Asset Management in London.

An investor in a first-loss tranche would typically expect a return from 8% to 10%, Renault says. To promote ESG goals, investors might accept a slightly lower return or a structure in which the interest rate declines if certain targets are met.

Capital-relief trades are placed each year on bank loan portfolios worth as much as $190 billion. Investors “can help the banks make a meaningful impact” so long as the capital freed up is redeployed “into loans with better ESG credentials than the hedged portfolios,” Renault says.

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Abrell says Standard Chartered’s Chakra deal has “a direct, positive impact from an ESG perspective” because of the nature of the collateral and the potential for freed-up capital to be used to finance similar initiatives, which helps Standard Chartered support further business growth in green projects.

Money Market Funds

Money market funds—pools of high-quality, short-term debt in which investors often park cash until they find better ­opportunities—also come in ESG flavors. The asset management units of Pictet, HSBC, and Morgan Stanley are among the providers of such funds.

Another is UBS Group AG, which started its first ESG money market fund in 2020—a version of its $4.9 billion UBS Select Prime Investor Fund. Robert Sabatino, who leads both versions from Chicago, says UBS portfolio managers have long considered ESG risk when making investment decisions. What makes the ESG-­labeled fund different is that he uses a proprietary tool to select borrowers that rank higher on the relevant factors, he says.

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Still, there’s a limited supply of short-term debt of sufficient credit quality. So the UBS Select Prime Investor Fund and the UBS Select ESG Prime Investor Fund are quite similar. Like many others in the industry, both funds are dominated by financial issuers. Both hold commercial paper or certificates of deposit issued by Barclays, Commonwealth Bank of Australia, Nordea Bank, and Toronto-­Dominion Bank, according to UBS fund data. The fee structure is also the same for both funds. The ESG fund outperformed in April, with a 30-day yield of 0.08% compared with 0.03% for the regular fund, the data show.

But what kind of impact can an ESG money market investor really have? UBS’s ESG money market fund holds debt with an average maturity of just 17 days.

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Sabatino points to the overall size and importance of the money markets, which provide companies with $5 trillion in short-term financing in the US. Engaging with companies over ESG issues is a significant component of UBS Asset Management’s ­sustainable- investing process, he says. He adds that he’s worked to ensure issuers of short-term debt are also covered by the efforts and that he’s exploring ways to engage directly with the companies in his portfolio. Climate change “is the biggest ESG issue for banks,” so it’s crucial to understand the details of their net-zero commitments and the progress they’re making toward climate goals, he says.

Eli Kasargod-Staub, the executive director of Majority Action, a nonprofit in Washington focused on responsible investing, questions how effective money market funds can be. While share­holders have power, such as the ability to vote out boards of directors, it’s unclear what levers commercial paper buyers really have, he says. If funds act alone, it’s unlikely they can succeed in pressuring borrowers to meet climate goals. But if they join together to take steps—such as excluding ESG laggards from their funds—that could create a powerful incentive for a company to shift behavior, he says.

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Synthetic CDOs

French bank BNP Paribas SA has found a way to sprinkle ESG on a synthetic CDO, a structure that allows investors to make leveraged bets on whether companies will keep paying their debts. Synthetic CDOs package derivatives called credit default swaps, which insure against bond or loan losses, on as many as 100 companies. In the BNP Paribas deal, structured in partnership with credit fund manager Zais Group LLC, the portfolio was filtered to prioritize the companies best placed to thrive in a low-carbon economy and exclude those involved in activities deemed particularly damaging to the environment.

The transaction was named Glasgow because it was issued in November to coincide with the United Nations Climate Change Conference in the Scottish city. Zais Group bought the equity in the Glasgow deal, getting a higher interest rate for agreeing to absorb the portfolio’s first losses.

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Investors in collateralized synthetic obligations, as deals such as Glasgow are also known, can choose the credits in the ­portfolio to ensure they’re ESG-focused, says Murray Parker, a BNP Paribas spokesman in London. The returns on offer in the Glasgow deal were lower than normal, he says, because about 90% of the portfolio’s credits are rated investment-grade, in contrast to less than half in a typical CDO. Companies with higher credit ratings tend to perform better on sustainability metrics but offer lower yields, Parker says.

The Glasgow portfolio’s average credit spread of three years—a measure of the premium investors receive for taking on risk—was about 50 basis points, half the typical spread on a non-ESG deal, Parker says. The companies in the portfolio include Spanish utility Iberdrola, French food giant Danone, and ­California-based printer company HP, he says. As of May 12, the three-year credit default swaps on Iberdrola were trading at about 46 basis points. Synthetic CDOs are ideal vehicles for ESG investors because they can potentially reduce the borrowing costs for selected credits, Parker says.

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Fajr Bouguettaya, who ran JPMorgan’s global credit correlation business, sees it slightly differently. While deals like Glasgow are unlikely to materially affect market pricing today, he says, over time the sustainable-investing movement will create pricing differentials between companies seen as more investable than others.

“CDOs, CDSs, bonds—these are all just ways to express a view on the market,” says Bouguettaya, who set up his own credit hedge fund, BirchLane Capital, in 2020. “In many ways the product is meaningless. What matters is what’s in the underlying ­portfolio—and does it align with your view of what is ESG and your environmental or social objectives?”

CLOs

Managers of collateralized loan obligations—bonds backed by ­portfolios of loans made to junk-rated companies—are also now labeling their deals ESG. Definitions vary in this nascent market, making it hard to quantify how many deals have been sold, says Conor O’Toole, global head of CLO research at Deutsche Bank AG in London. Issuance of “actively labeled ESG CLOs” has totaled $33 billion since 2018, O’Toole says. Insurance giant Axa SA and investment firm Fidelity International are among the CLO managers that have brought these deals to market.

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Invesco Ltd., a $1.5 trillion investment firm, issued its first US ESG deal in November and followed up with another in March. There is a lot of overlap in the loans backing both CLOs and those packaged into its prior non-ESG deal, which closed in June 2021. Both include loans to Air Canada, Carnival, McGraw-Hill Education, and Windstream Services, data compiled by Bloomberg show. About 5% of eligible loans are excluded by the firm’s ESG criteria, says Ian Gilbertson, CLO portfolio manager at Invesco. This “eliminates the largest ESG tail-risk borrowers from inclusion,” he says, declining to name specific credits rejected from the ESG deal.

The fees for the two deals were identical, Gilbertson says. The difference in yield—at 1.33% for the initial coupon on the ESG deal vs. 1.24% for the non-ESG CLO—was simply a reflection of market conditions when securities were issued, not an indication that investors would typically receive a premium on ESG notes.

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Invesco actively engages with corporate borrowers included in CLO portfolios on the importance of improving on ESG goals, often identifying potential problems and forming an action plan to monitor and reduce them, Gilbertson says. In one case, pressure from Invesco led a pharmaceutical company to make its first sustainability commitments, including a target for emissions reduction and a goal to power all of its operations with renewable sources of electricity, he says, declining to identify the company.

Fidelity International, which last year priced a CLO aligned with Article 8 of Europe’s new sustainability disclosure rules, also sees engagement with corporate borrowers and deal sponsors as part of its contribution to change, says Camille McLeod-Salmon, a ­London-based portfolio manager for private credit. The ESG deal can support companies with the best ESG transition policies, limit funding for those companies that aren’t appropriately engaging with the risks, and help companies develop a net-zero transition pathway, she says.

“Pricing benefits for CLOs integrating ESG factors may not be explicit,” she adds. Still, Fidelity has “the resources, relationships, and research to effect change.”

Marsh is an ESG reporter at Bloomberg News in London.