Since S&P Global Ratings published its last green covered bond report, the issuance of environmental and social themed covered bonds has steadily risen (see "What's Behind The Rise In Green Covered Bond Issuance?," published on June 26, 2018). While growth in the overall sustainable covered bond segment has perhaps not fully met the some market participants' high expectations, social themed covered bonds have emerged as a new flavor of covered bonds over the past year, as issuers are looking to align their public sector and mortgage loans with broader social objectives.

This credit FAQ describes the recent developments, opportunities, and challenges facing the sustainable covered bond market, the nature of the collateral backing social bonds, and how we measure the social impact. We also consider the benefits of the covered bond structure in enabling environmental and social finance, how the structure supports good governance, and describe how we capture green and social factors and overall environmental, social, and governance (ESG) performance in our credit rating criteria.

Table 1

What's Changed In The Sustainable Covered Bond Market Over 2018-2019?

Over the past year, the issuance of ESG sustainable covered bonds, which includes both green and social bonds, has continued to expand, with current 2019 volumes reaching 90% of 2018 full year issuance. The European commission, the Association of German Pfandbrief banks (vdp), and various other market players have worked on common definitions and guidelines to help introduce capital market standards. However, standards for sustainable covered bonds issuance remain diverse and although volumes are expected to exceed 2018 by year end, the growth in new issuance for green covered bonds has so far been somewhat lower than expected. Nonetheless, recent new entrants to the market include issuers from France (CAFFIL, Société Générale SFH), Denmark (Nykredit, Realkredit Danmark), Poland (PKO Bank Hipoteczny, the first issuer of green covered bonds in Central and Eastern Europe), and Korea (KHFC, the first issuer of social covered bonds in Asia).

Figure 1

Green covered bonds remain the main sustainable covered bond type with energy-efficient and green real estate financings accounting for approximately 75% of issuance over the past year. However, in the last 12 months, there have been several issuances of a new type: the "social" covered bond. Although we still consider these instruments to be in their infancy, they add a new dimension to the sustainable covered bonds market and the broader sustainable finance market.

Figure 2

What Are The Challenges For Sustainable Covered Bonds?

Despite the steady continued rise in sustainable covered bond issuance, the rate of growth remains below market expectations, and outstanding sustainable covered bonds (currently about €14 billion) still represent a very small proportion of the entire covered bond market (approximately €2.5 trillion). Some of this may be down to a lack of common standards and definitions but sustainable covered bond issuers also face a number of potentially costly administrative challenges when setting up green or social covered bond programs. Issuers must identify the relevant sustainable assets, prepare separate documentation, and set up reporting systems. Unsecured sustainable bonds are generally considered easier to document and manage. Add that sustainable characteristics are not necessarily rewarded in the current low interest rate environment, and the case for sustainable covered bonds becomes less compelling. Nevertheless, in our view, high growth potential remains due to strong political support, increasing investor demand, and the potential match between the covered bond funding instrument and sustainable finance objectives. We also expect that some of the establishing costs are likely to decline as the market matures. We expect the relative share of sustainable covered bonds to rise significantly as banks increase their focus on underwriting environmental and socially-focused assets and regulators enact measures to promote sustainable finance.

Why Has Sustainable Covered Bond Issuance Increased?

The rise of sustainable covered bond issuance has resulted from several factors, including:

• Reputational benefits: Enhancing the corporate social responsibility standing of the issuing banks and demonstrating their commitment to the United Nations Sustainable Development Goals (SDGs).
• Diversification of the investor base: Attracting new buyers with an ESG mandate who would otherwise not be natural covered bond investors.
• Establishing a presence in the sustainable finance market: Creates favorable conditions for the funding of assets with social and environmental value add.

Chart 1

In addition to the above factors, issuers we have canvassed consistently reported that sustainable covered bonds attract greater investor demand in the book building phase, leading to a potential sustainability premium. Yet, due to the accommodative monetary policy of the main central banks, it is difficult to identify conclusive evidence for the price premium for sustainable covered bonds compared to ordinary covered bonds. Nonetheless, there have been cases of recent green bond issuances on which the issuers claim that they have achieved a price premium, or "greenium".

How Suitable Are Covered Bonds As Assets For Sustainable Financing?

In our view, covered bonds may be considered conducive vehicles for environmental and socially focused transactions because cover pools of mortgages and public sector loans can be separated, identified, and aligned to environmental and social objectives. Residential and commercial mortgages may support green bonds where the loans are for properties that are either built or refurbished to certain green standards, as in recent issuances from Berlin Hyp and DnB, or social bonds where loans are for affordable housing, as with issuance from KHFC in South Korea. Additionally, public sector financing may lend itself to social bonds given the role of the public sector in supporting local communities and achieving societal benefits, thereby allowing a series of initiatives by local and regional governments (LRGs) to be developed. For example, the social covered bond issued by CAFFIL in France to finance loans to public hospitals.

Covered bonds also offer unique advantages for issuers of environmental and social assets. The dual recourse nature, dedicated legislative frameworks, favorable regulatory treatment and public supervision--which are all components of a strong governance regime--support reduced funding costs, relative to senior unsecured debt. Cost benefits, in turn, may be transferred to green homeowners and the public sector to facilitate greater environmental and social benefits. The potential long maturity of covered bonds compared to unsecured debt is an additional advantage when funding long-dated assets, which are present in both green and social covered bond pools.

Additionally, while larger LRGs generally have access to direct bond issuance through the debt capital market, most local authorities, which often face constrained budgets, rely exclusively on the loan market as a source of funding for public investments. Covered bonds allow banks to offer more favorable conditions on loans to these local authorities, including for social investments, thereby providing an important funding source for local authorities to achieve positive social impacts.

Figure 3

How Do Social Covered Bonds Report Their Impact?

For covered bonds to be considered "social" by investors, they need to demonstrate that the transaction is contributing to some form of social impact. However, given that social bonds are still in their infancy, measuring, assessing, and reporting social impact is an important area of focus for issuers and investors. Through our review of several social covered bonds to date, we have identified the following sample of social impact indicators:

• Hospitals: Number of places (partial hospitalizations where treatments are less than one day) and beds (for complete hospitalization where medical treatments exceed one day); total number of cases per hospital (partial in-patient cases, outpatient cases); number of facilities, patients or beds, and/or population of regions where hospital/nursing home/rehabilitation center/psychosomatic center projects are located.
• Affordable housing: Number of households benefiting from mortgage loans, average household income of borrowers; number of vulnerable individuals or families benefiting from subsidized housing or number of dwellings, number of elderly persons benefiting from projects supporting homecare for elderly persons or number of dwellings.
• Education: Number of public education schools supported and/or number of individuals benefiting from these schools.
• Multiple: Contribution to the UN's Sustainable Development Goals (SDGs) target population according to the German Federal Institute for Research on Building, Urban Affairs and Spatial Development (BBSR) Indicator, which involves the percentage of the overall population served in regions that are shrinking at an above-average rate or which do not show a clear development direction.

We expect numerous flavors of social asset types and impact measures to emerge given the relatively broad nature of what could constitute a social issue and/or social outcomes and the lack of any standardization or taxonomy for the market to follow. In our view, investors will need to be more discerning in their assessment of the social attributes of these transactions to ensure that the bond agrees with their ideas of social outcomes. Nonetheless, we believe covered bond programs that fund green mortgages and public sector assets may offer the unique advantage of supporting low-cost funding for the sustainable finance market.

Figure 4

How Does S&P Global Ratings Consider ESG Factors In Its Covered Bond Ratings?

The starting point of our rating analysis for covered bonds is the issuer credit rating (ICR) on the issuing bank, which has an obligation to repay the covered bonds while it is solvent. This approach recognizes the dual recourse nature of the instrument where the collateral pool acts as the second level of repayment support in case of issuer default. Our credit ratings have long considered ESG issues that are material to credit quality, that is when ESG factors impact an issuer's ability and willingness to meet its financial obligations in full and on time. When an ESG exposure is material enough to influence our opinion of credit-relevant factors such as an entity's competitive position, management and governance, and/or its cash flow and leverage forecast, ESG analysis is relevant to the credit rating and, in some cases, could drive credit rating actions. But there are instances where mitigants, such as a very strong balance sheet and cash flow, can materially offset ESG risks in a credit rating.

When assessing the credit profile of the covered bond-issuing bank, we consider a number of ESG factors for our ratings. Our financial institutions analysis typically considers ESG factors in the context of the Banking Industry Country Risk Assessment (BICRA), risk position, and governance assessments. Our analysis of ESG risks and strengths also permeates our bank rating methodology and is included in our assessment of a bank's risk position, which incorporates risks that are not captured directly in our capital model. For further information, see "How Environmental, Social, And Governance Factors Help Shape The Ratings On Governments, Insurers, And Financial Institutions," published on Oct. 23, 2018. In this way, our covered bond ratings capture the underlying ESG performance of the issuing bank.

How Do Social Factors Influence Credit Risk?

While environmental factors may indirectly influence the credit quality of a mortgage collateral covered bond pool through factors such as higher valuations, social factors do not typically affect credit quality and instead provide an ancillary societal benefit. More specifically, our ratings criteria for public sector collateral make no direct references to social factors for the assessment of credit risk. A use of proceeds dedicated to achieving social objectives is unlikely to mitigate credit fundamentals such as obligor default risk. As such, there is no specific credit impact attributed to socially focused transactions compared with ordinary public sector assets.

In current covered bond programs, green and social covered bonds are backed by the entire cover pool, not just the respective green or social assets. Due to this cross-collateralization feature, there is no differentiation in creditworthiness between green/social and ordinary covered bonds. A potential future development may be the creation of green or social dedicated covered bond programs, reinforcing the full sustainable credentials of the underlying cover pool.

Related Criteria

• Covered Bonds Criteria, Dec. 9, 2014
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• Why Sustainability Linked Loans Are Taking Off, Sept. 3, 2019
• S&P Global Ratings’ Covered Bonds Primer, June 20, 2019
• How Environmental, Social, And Governance Factors Help Shape The Ratings On Governments, Insurers, And Financial Institutions, Oct. 23, 2018
• What's Behind The Rise In Green Covered Bond Issuance?, June 26, 2018