Rates Commentary - Internals
NWM Rates: Talk of the town - Green Gilts

On 9 November 2020, the Chancellor of the Exchequer announced: “To meet growing investor demand, the UK will, subject to market conditions, issue our first ever Sovereign Green Bond next year. This will be the first in a series of new issuances, as we look to build out a ‘green curve’ over the coming years, to help fund projects to tackle climate change, finance much-needed infrastructure investment, and create green jobs across the country. Since the announcement there has been a steady stream of rhetoric from HM Treasury, the UK DMO and the Bank of England regarding the UK’s intention to develop their climate change agenda and the role that green gilts have to play in it.


The first Green issue is expected to come to market in September of this year, with the expectation of second issuance by December. Total Green issuance for the 2021/22 financial year has been announced as a minimum size of £15bln, which is included in the £28bln of unallocated portion of issuance. More recently, the DMO publicised that market participants can expect further details of the green gilt framework in June. This will provide guidance on ‘Use of proceeds’ categories eligible under the green gilt programme and other practical details, e.g. what happens to investors’ money before it is invested to ensure it is not mixed with non-green gilt money. We expect the framework to be aligned with the International Capital Markets Association’s (ICMA’s) Green Bond Principles and to indirectly align with the EU taxonomy criteria, given the UK recently announced the development of a UK Taxonomy which will be supported by the Green Technical Advisory Group (GTAG) established by HM Treasury.


Chart 1: European Green government bonds and the 'greenium'

Source: NatWest Markets

In our previous piece we highlighted the growing demand for Green, Social and Sustainable (“GSS”) bonds and a guide to the issuance framework. For further discussion around what is typically included in a green bond framework you can read more here.  We also mentioned the growing demand and need for GSS issuance, given the challenge the world is currently facing as we combat climate change.  As such Green bonds have seen increased demand especially over the last two to three years.  More sovereigns are issuing green bonds and building out their curves given this increased demand from investors, but most importantly to fund their increasingly green expenditures. The chart (Chart 1) above shows a snapshot of the where the green bonds are trading relative to conventional's for the respective issuers. The 'greenium' is driving demand for issuers of green bonds giving them a chance to build up overly subscribed orderbooks. This is also a testament for the demand present for green bonds given the tighter pricing.


The drivers behind issuing green gilts and the UK’s 10 point plan

At the end of 2020, the government announced a focus on a greener economy and ‘building back better’ while accelerating the path to Net-Zero. The 10 point plan aims to focus on the key areas of growth to positively shift the economy more eco-friendly by focusing on:

  1. Advancing offshore wind;

  2. Driving the growth of low carbon hydrogen;

  3. Delivering new and advanced nuclear power;

  4. Accelerating the shift to zero emission vehicles;

  5. Green public transport, cycling and walking;

  6. Jet zero and green ships;

  7. Greener buildings;

  8. Investing in carbon capture technologies;

  9. Protecting our natural environment; and

  10. Green finance and innovation.

Following this announcement the government has since launched other programmes where there has been an increased focus on reducing fossil fuels from the UK economy. There has been an increased attention on climate change given the most recent G7 summit and the upcoming COP26 (sponsored by NWM) in November – both of which are hosted by the UK. One can expect the green gilt framework to focus on some of the key elements from the 10 point plan. Away from this, there has also been increased interest in responsible investing from the investor perspective, given the stricter rules around reporting and the impacts on portfolios. We have seen this additional emphasis across all LDI accounts which we highlighted in our Markets Pensions Monthly.

Additionally in May, HM Treasury (HMT) and the UK DMO announced the creation of a Stakeholder Discussion Forum (SDF) on the UK government's plans for issuance of green gilts and a retail green savings product.  The main purpose of the SDF is to bring together a small group of highly respected experts, who will be able to provide external perspectives to the HMT and DMO, bringing specialist with technical knowledge to this landmark initiative.


Pricing & Liquidity

Green gilts will hold the same underlying features as conventional gilts; however the main element setting it apart is the use of proceeds. Green bonds are normally ranked the same as the issuers’ conventional gilt and they also do not carry any additional credit enhancements. The key element setting them apart, in terms of pricing, is the implied ‘greenium’ associated with the maturity which should imply a lower yield when compared to their equivalent conventional. This is being driven by notable investor demand in GSS assets with demand still outstripping supply, despite the surge in issuance ytd. Oversubcription levels for GSS issuance exceeds that for conventional on average, leading to the sustained emergence of a greenium. 

Green bonds have typically followed similar liquidity and pricing patterns to conventionals, mainly to ensure investors are able to switch in or out without attracting significant costs. For similar reasons, Germany launched their twin green bond allowing investors to switch between the green and conventional bund with complete transparency on pricing.


Chart 2: Greenium Exists across almost all  European Sovereign green bonds as they all trade richer on the curve given the low interest rate environment

Source: NatWest Markets

Despite the increase in supply, demand for green bonds has been strong and a  ‘greenium’ is now considered the norm. In the chart above (Chart 2) we see enhanced levels of greenium being led by the French and Italian green bonds as recent issuance was priced extremely rich compared to the traditional non-GSS curves. This is also evident in the order-books, which benefit from greater oversubscription; France and Italy’s sovereign green bonds saw order-books that were 5 and 9 times oversubscribed, respectively. By contrast, conventional bonds have been 2.5x covered on average this year for France and Italy.  A similar trend has been noticed in the EU Sure and NGEU social bonds.


UKTG - 10yr vs 20 yr - Investor demand and views

Investors have showed interest in green issuance from the UK for a while now, certainly from a long time before the DMO and treasury raised the prospect of green issuance. Given the increased focus on ESG and fiduciary pressures, there is a desire, and requirement, for certain investors to ensure their portfolios are incorporating the ESG impacts (both positive and negative) of investments.


When looking at how any green gilt will be bought, it’s important that the investor base have enough time to prepare, especially if the DMO is looking to issue at a premium to the current gilt curve. Many mandates are rigid when it comes to bond investment and so while there may be a desire to invest in green securities, there may be restrictions on obtaining the best value for money outcomes for the underlying client. In order to mitigate these, investors need as much notice as possible to address potential issues in their IMAs.” – said Simon Clark, NWM, LDI Rates Sales 


Real Money and LDI accounts have both shown an increased interest in green gilts, however actual demand will be dependent on the green framework and maturity. Investors, given current mandates and fiduciary duties, may be reluctant or unable to pay a specific green premium for the issue as seen with German twin green/brown bonds. Picking a gap in the current curve allows for RV pricing reflecting a potential green premium while still allowing LDI to purchase the bond.


The maturity choice mostly boils down to the type of buyer the DMO are looking to attract initially; 10yr issuance will attract international investors as well as other investors such as bank treasuries who would look to include the green gilt in their liquid asset buffer portfolios. Counter to this they may choose to issue around the 20yr sector to bring in the LDI portfolios which typically hold a lot less gilts sub 15y. LDI would typically not own many 10 year gilts and instead hold either credit assets or derivative hedges at that tenor point instead. A Jan 2033 maturity for the 10 year and for the 20yr a July 2043 look best placed to attract the most interest. However, given the DMO’s intention to issue two green gilts this year, it is likely we will see a longer maturity as they honour their commitment to building out a green curve.  


Following the latest consultation it’s expected that the inaugural Green Gilt will be issued in September with the likelihood of a maturity in the 10 to 12 year area for the first transaction although there were some calls for 20yr. Given the success of last year’s October 2030 syndication, it’s clear that there is going to be strong demand for this type of maturity, but perhaps something around 20yr offers a better fit on the Gilt curve .The final decision is likely to be made at the August consultation and we think the decision is going to come down whether the DMO want to attract a diverse international investor base or focus more on the domestic LDI portfolios. Either way, as we have seen in recent Green sovereign issuance in particular, it’s likely to see very strong order-books and create pricing tension” said Kerr Finlayson – NWM’s Head of FBG Syndicate  


Chart 3: 10s20s Historic Spread Comparison (2020-YTD)

Source: NatWest Markets, Bloomberg

As you can see from the chart above (Chart 3) while the curve has steepened up since the height of the pandemic last year, 10s20s has flattened around 10bps from the peak. From here it will be interesting to see how the new UKT39s syndication is received, but its worth noting that LDI demand for gilts 20y+ tends to be robust. It will be interesting to see where the DMO issue the inaugural green gilt given both the 10yr and 20yr may present a strong case at the current levels. Ultimately given the stated goal of building a green curve we expect there to be something for everyone over the coming quarters.


While the market expectation is for the inaugural Green Gilt to come in the 10y sector, the DMO will be cognisant of investor feedback, given the importance of successful first issue. While the shape of this quarters issuance calendar has been cited as the reason for the shorter tenor, we feel the chances of the first issue coming in the 20y sector is being underestimated said Scott Marsh – NWM’s Gilt Trading


Green Gilts – so what’s next?

More recently the UK announced the GTAG to advise on creating a UK taxonomy for sustainable activities, similar to the EU Taxonomy. The 18-member group will advise the UK government on implementing taxonomy to drive informed decisions on environmentally sustainable investment and aims to include a technical screening criterion on particular economic activities. The UK taxonomy will build on existing international models, including the EU’s, and will focus on becoming net-zero in the UK context, aligning it with the Green Finance Strategy. We should see the development of more ESG focused funds from LDI, and real money accounts, given the expansion of global ESG interest. One can also expect a stricter reporting expectation and requirement from investors and other market participants as the taxonomy evolves. One of the main concerns from investors currently is the level of ‘greenness’ for use of proceeds for green gilts and similar products, however stricter reporting and accountability regimes should help to tackle such concerns.


Given the UK’s presidency, alongside Italy, of COP26, the timing is ideal for the UK to enter the green bond sovereign market – further underpinning its commitment to reach net-zero greenhouse gas emissions by 2050 or even more ambitiously to reduce emissions by 78% by 2035 (relative to 1990 levels).  This financing will support Green Expenditures that will support these efforts. said Caroline Haas – NWM’s Head of Sustainable Finance FI’s and SSA’s.

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Rabia Sheikh
Real Money Rates Sales
+44 20 7085 9463

Caroline Haas
Michaela Rizzo

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