Green Junk Bonds May Not Deliver Green Results

By Matt Wirz

Wall Street is selling a record number of junk bonds meant to finance environmental projects, but many have an important catch: The borrowers don't guarantee that they will use the money for green purposes.

High-yield rated companies including Irish packaging maker Ardagh Group SA and U.S. car-parts manufacturer Dana Inc. have issued green bonds this year. Some of the borrowers used the cash to repay debt, finance a SPAC deal and for other corporate expenses, promising to spend equivalent sums on sustainability in the future.

Many of those bonds also included fine-print warnings that the companies might not fulfill their environmental pledges, according to documents reviewed by The Wall Street Journal. Money managers are so eager to buy green-labeled investment products that they are disregarding the potential risk that the bonds aren't as green as advertised, bond lawyers and analysts said.

"This poses a dilemma for the green-bond investor," said Henry Shilling, founder of Sustainable Research & Analysis LLC and one of the first credit analysts to focus on green bonds. "You need to account for the risk that you are holding something that, in the end, may turn out not to be green."

The rise of junk-rated green bonds is part of a surge in sustainable investing, as money managers and investment banks race to adapt to changing customer demand. The transformation has raised concerns of "greenwashing," or mislabeling funds or securities as green, and the European Union in March enacted new regulations to curb the practice.

Bankers who sell high-yield green bonds said there have been no public cases of a green-bond issuer intentionally reneging on its environmental commitment, although a few have restructured their debts for financial or political reasons.

Dana is committing to electric-vehicle technology and cutting greenhouse gas emissions at least in half by 2035, a company spokesman said. "We are confident that the proceeds from our $400 million green-bond offering will be used exclusively for eligible green projects," he said.

Companies that issue green bonds create frameworks specifying the use of proceeds for objectives like transitioning to renewable energy. They also hire third parties to verify that the objectives are being met. If a borrower fails verification, however, bondholders have no legal right to seek compensation.

"There are no mechanisms to ensure investors that the green investment will actually occur," said Mitu Gulati, a law professor at the University of Virginia. "The only conclusion I can draw from that is that investors don't actually care. It's so much eyewash."

That wasn't viewed as a risk when green bonds were first issued about a decade ago by investment-grade borrowers with long-held sustainability commitments, such as the World Bank. Recently, companies with high-yield credit ratings started selling more green bonds, including their explicit warnings in investor documents.

Issuance of green bonds hit a record $270 billion last year and is on pace to exceed that amount in 2021, according to data from the Climate Bonds Initiative. The share of below investment-grade bonds was an estimated 3.2% in the first quarter of 2021, but is growing fast, up from 2.5% for all of last year and 1.2% in 2019, according to an analysis by Sustainable Research & Analysis of data from Dealogic.

Luxembourg-based packaging manufacturer Ardagh issued $2.8 billion of high-yield green bonds in February to fund the partial merger of its metal-cans unit to a SPAC, or special-purpose acquisition company. Ardagh Chairman Paul Coulson negotiated the deal with the SPAC company's chairman on yachts in the Bahamas, and its announcement helped fuel a roughly 31% rise in Ardagh's stock price.

Institutional Shareholder Services Inc. certified Ardagh's green-bond program based on its commitment to use an amount equivalent to the proceeds on programs such as purchasing more recycled materials and increasing energy efficiency.

"No assurances can be provided that allocation to projects with these specific characteristics will be made by us with respect to an amount equal to the net proceeds from the notes," Ardagh stated in its bond document. "There is no guarantee as to the environmental and/or social impacts of the eligible green projects."

"We are absolutely sure we'll be spending that amount of money on uses that are in line with our green-bond framework, and we will report on that each year," said John Sheehan, Ardagh's investor relations director.

Bond language has unusually biblical overtones -- investor protections are called covenants -- and when a company or government violates those proscriptions, it can be sued for repayment and damages. In the case of green bonds, the only loss to a borrower for failing to fulfill its environmental pledge is reputational.

"There's really no teeth here," said Jason Ewart, a lawyer on debt deals at Latham & Watkins. "Investors have no recourse -- there's just egg on the face of the issuer in the green-investing community."

The public-relations fallout that accompanies failing to fulfill a green-bond program is a significant disincentive to borrowers, most of whom issue the bonds to burnish their environmental credentials, bankers who work on the transactions said.

One alternative that Wall Street bankers and lawyers started to offer environmental, social and governance, or ESG, investors last year is sustainability-linked bonds. Rather than pledging proceeds to specific green projects, borrowers commit to meeting sustainability targets that they select, such as reducing carbon emissions. If they miss the target, they must pay a higher interest rate.

German engineered-wood manufacturer Pfleiderer Group BV issued EUR750 million, equivalent to roughly $914 million, of sustainability-linked bonds through subsidiary PCF GmbH in April rather than green bonds, aiming to increase its use of recycled materials by 4 percentage points to 44% of total materials and reduce its carbon footprint by 8% by 2022.

"It was a question of the use of proceeds," said Pfleiderer Chief Financial Officer Mani Herold, who used the bonds to refinance existing debt. "We wouldn't have had a [green] project that was large enough for that amount."

Wall Street is pushing the new product in part because it will allow the sale of more bonds with an ESG label by including companies that, like Pfleiderer, don't have large-scale green projects to fund. New sales of the bonds hit $8.5 billion in this year's first quarter, equal to the total issuance in all of 2020, but the methodology that companies apply varies widely, according to Moody's Investors Service.

The penalties for failing to hit sustainability-bond targets are often too small to be meaningful, said Alastair Gillespie, an analyst at research firm Covenant Review.

Pfleiderer's interest expense would increase about $2 million annually if it failed to hit both of its targets. Investors who participated in marketing meetings before the deal didn't negotiate for a higher step-up, Mr. Herold said.

"The market is in its infancy, and its deficiencies are now becoming better known," Mr. Gillespie said. "If fund managers decide what's happening isn't good enough, there will be a natural desire for it to evolve."

Maureen Farrell contributed to this article.

Write to Matt Wirz at matthieu.wirz@wsj.com

(END) Dow Jones Newswires

June 09, 2021 07:14 ET (11:14 GMT)

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