In December 2021, NN Investment Partners’ Bram Bos predicted the death of the transition bond market. The much-hyped label, intended to capture transitional expenditures that were not truly dark green, had failed to generate much enthusiasm and potential issuers had largely turned to sustainability-linked bonds.

Yet it has stubbornly refused to die. National standards brought out in China and Japan have kept the label alive, along with occasional issuance by the likes of Italian energy firm Snam.

The label still divides opinion among investors. Among the naysayers is Mirova’s Charles Portier, who claims investors have been “seduced” by green bond spin-offs such as blue or transition bonds.

“Transition bonds, like blue bonds, have a marketing purpose,” he says. “They try to seduce investors with new types or products but it’s creating more confusion than clarity regarding ESG.”

Portier is restricted from investing in gas projects, which means he would in any case be unable to buy many transition bonds.

For Johannes Boehm, senior ESG analyst at Germany’s Union Investment, transition bonds are complementary to the sustainable bond market and can be a way of flagging progress on climate issues to investors.

“If you have a strong transition story to convey to the market, then as an issuer you may want to call the issuance a transition bond,” he says.

He notes that the label also adds value by provoking dialogue between issuers and investors. “Investors and issuers have had a dedicated discussion on green topics more broadly in the past because of green bonds. Transition bonds have fostered exactly that dialogue with regards to transition.”

Differing definitions

A key problem for the market is that there is no consensus on what would constitute a good transition bond should look like or how it should be differentiated from a green bond.

This problem was evident to the working group which produced ICMA’s climate transition finance handbook in 2020.

“There was an overwhelming majority of a very large working group that felt very strongly that if we’re talking about things which make a substantial environmental impact with no lock-in they come under green bonds, so you couldn’t really distinguish them in that particular way,” says Isabelle Laurent, deputy treasurer and head of funding at the EBRD and chair of ICMA’s principles.

“If it’s in the more difficult sectors, so it’s not net zero or near zero, how you underpin the robustness of that is not just through the impact reporting and benchmarks and showing the level of ambition, but also through these additional aspects of looking at transition plans and using science based targets.

“The minute you’re doing that, you’re essentially underpinning a bona fide green bond.”

The EBRD has a “climate transition” label for bonds – however, these are issued under the bank’s green bond framework.

A number of asset managers interviewed for this piece said they would only consider buying transition bonds for dedicated funds if they were aligned with the Green Bond Principles.

Boehm admits that the lines “are a little bit blurry” between the two labels.

Stephen Liberatore, head of ESG/impact for global fixed income at Nuveen, agrees that there is overlap between the two.

He argues that a transition bond should capture technologies that are not only a change in the issuer’s business model, but would also be indicative of “a broader sectoral opportunity”.

“Whether it’s a transition or it’s a green bond, that use of proceeds and that direct and measurable concept will do you the most benefit because it will attract the largest amount of investors that are looking for those specific investments”
Stephen Liberatore, Nuveen

Despite having evaluated every transition bond that has come to the market, Nuveen has only participated in one deal – a £500 million bond issued by Brazil’s Marfrig in 2019.

The beef producer allocated the proceeds from the deal to buying cattle from land where satellite monitoring showed there had been no deforestation. “If you are able to satellite monitor and track, then you’re able to identify calves that have been on deforested land and not use those,” says Liberatore.

“We believed that if Marfrig could do it, then all the other protein providers could do it as well, which would be a true change in their industry that would have a material environmental benefit.”

Again highlighting the intersection between green and transition, Liberatore names several green bond issuers from whom he would consider buying bonds with a transition label. One is Australian iron ore producer Fortescue Metals Group, which is trying to create circular processing for iron ore and steel fabrication.

“That, to me, would be an indication that if FMG can do it then the rest of the industry could do it as well,” says Liberatore. “That would fit our definition of transition.”

UK manager Insight Investment takes a slightly different approach. The firm’s Responsible Horizons funds buy both “impact bonds” and “impact issuers”. While transition bonds would not be eligible on the security side unless they were taxonomy-aligned, issuers who are targeting Paris alignment could fall into the second category.

As an example of impact issuers, Insight has looked at cement producers, which are not currently taxonomy-aligned but are setting CapEx plans to align with the Paris Agreement over time.

One of the major differentiators of transition bonds from green is that they allow for the funding of fossil fuel projects. Japan’s Kyushu Electric Power Co, which raised ¥55 billion ($383 million; €351 million) from 2022’s largest transition bond deal, includes the construction of high-efficiency thermal power plants in its transition financing framework.

Similarly, the Climate Bonds Initiative said that Daido Steel Company’s ¥27 billion transition bond contained measures ineligible for its assessments, such as financing a switch from kerosene to LNG for steelmaking and casting facilities.

That can make bonds ineligible for investors who exclude fossil projects, even though green expenditures are mixed in. Both Kyushu Electric Power and Daido Steel provide for the installation of renewable energy in their frameworks.

Labels in competition

Another headwind for the transition bond market over the past four years has been increasing competition from sustainability-linked bonds, which are also touted as a labelled solution for issuers without enough green expenditure to warrant going green.

SLBs have partially replaced the need for transition bonds, explains Alban de Faÿ, credit portfolio manager and head of fixed income SRI processes at Amundi.

The firm is an influential buyer of green bonds, holding €7 billion in its dedicated funds and €32 billion in total. Transition bonds are ineligible for its green bond funds, but other managers are free to buy them if they like the deal on the grounds of both ESG quality and fundamentals.

If an issuer is currently behind on climate but has a strong commitment to reduce carbon intensity, an SLB is “a very nice tool” and a complement to green bonds, says de Faÿ. “It helps all issuers come to the sustainable market regardless of whether they have enough green projects or CapEx.”

For Liberatore, issuing a use-of-proceeds bond is a better option to attract sustainable investors. “Whether it’s a transition or it’s a green bond, that use of proceeds and that direct and measurable concept will do you the most benefit because it will attract the largest amount of investors that are looking for those specific investments,” he says.

On the use-of-proceeds side, Mirova’s Portier is happy with the green label on its own. “You can do a transition with green bonds, so why should you create another form of ‘transition’ bond?” he says. “I don’t get it.”

Green, social and sustainability bonds are “doing the job really well”, he continues. “You get almost everything you need within green bonds. We don’t need all those types of product.”

Policy frameworks

Looking at the two markets where transition bonds have taken off, Japan and China, investors note the role played by a supportive policy and regulatory environment.

In 2022, overall volume of issuance in the format was up just 5 percent year-on-year. In the same period, however, the number of deals almost tripled. Similarly, the number of issuers rose from nine in 2021 to 25 in 2022 – in both cases largely driven by Japanese and Chinese heavy industry, according to figures from the Climate Bonds Initiative (CBI).

Italy leads the market in terms of total issuance volume to date but that comes from only five deals, whereas Japan has seen 21 deals and China 16.

The CBI includes the EBRD’s green transition bonds in its transition bond list.

In Japan, the transition bond market has followed the blueprint for successful label development. National guidelines are in place, and the government is looking to issue its own series of green transformation bonds, which it hopes will provide a template for private-sector issuers.

“What has been critical in the Japanese and Chinese context has been that policy support, the consistent frameworks and the sector-specific roadmaps,” says McNeil.

Japan could also provide a useful template for other jurisdictions looking to nurture a transition market – but so far there appears to be little interest. Canada’s taxonomy is set to include transition activities, but outside of Japan and China there have been few regulatory interventions which would support a transition bond market.

On the voluntary side, ICMA’s refusal to issue transition bond principles is often cited as a stumbling block.

Market participants note that the template for establishing a new bond label includes a dedicated set of principles, widespread SSA issuance and policy support – but with transition bonds two of these factors are absent and the third is patchy at best.

Another challenge is convincing issuers to come to the market. For Liberatore, the problem is twofold. First of all, a “material portion of the investor base” is not interested in investing in hard-to-abate sectors, which makes it difficult to scale the market.

But the main reason for issuers to avoid any labelled securities is greenwashing concerns,” he says. “The more complex the transaction or the higher the bar they’re trying to hit, the greater the likelihood is that an issuer may feel pressured, even if they’re trying to do the right thing.”