The announcement by President Biden on 22 April of a target to halve US greenhouse gas emissions by 2030 (from 2005 levels) and his announcement last month “to create millions of good jobs" in clean energy, electrified transport and general decarbonisation will generate opportunities for bond investors and transform the US bond market.
In line with the new target and its ’American Jobs Plan’ (AJP), the US government aims to spend over $2 trillion this decade on infrastructure projects. These are broadly defined as activity related to carbon emissions reduction, climate change resilience and ensuring inclusive growth and social equity during the low-carbon transition. This could lead to the following changes for US bondholders.
1. Green/sustainable bond market comes of age
The green bond market has grown rapidly since the Paris Agreement was signed in 2015, but still accounts for just 1 per cent of global developed market debt. The US has fewer issuers than the size of its economy should warrant. But the proposed $2 trillion of spending, aimed squarely at improving environmental and social sustainability, opens the door for a significant increase in US green government bond issuance (or ’Greasuries’ pending a better title), and sustainable bonds generally.
Companies seeking additional funding as they build utility infrastructure or capacity for zero-carbon transport will add to this green fiscal boost. Some portion (likely most) will be funded through the debt markets, and much of it will be issued in a green, social or sustainable format.
Meanwhile, across the Atlantic, the European Union is due to launch its €800bn Next Generation EU programme designed to rebuild economies after Covid-19, of which a third could be financed using green bonds. Increased supply would bring sustainable finance fully into mainstream debt investing and ease the current imbalance of high investor demand and limited green and sustainable supply, potentially making these kinds of bonds cheaper and more liquid.
2. Evolution in credit risk for different sectors
The US spending plan is likely to reduce credit risk in beneficiary sectors while increasing it in sectors that lose out from this transformation, offering opportunities for active credit managers to add value. However, shifts in the cost of capital for different sectors could be rapid and therefore require close monitoring.
3. Changing M&A targets for legacy firms
A merger is not always good news for corporate bondholders, as the new company’s credit quality will depend on the relative credit strengths of the target and the acquiror as well as the funding mechanism. In the past, legacy fossil fuel industries have adopted different strategic responses to the shifting energy complex, split broadly down geographic lines. US oil majors have sought to capitalise on the depressed valuations of US oil and shale producers to pick up cheap resources (such as Chevron’s acquisition of Noble), while the European oil majors, driven by a much greater regulatory and investor focus on decarbonising, have paid full valuations for clean energy assets and infrastructure.
Now, however, that picture could change as US energy companies are encouraged to invest in clean energy. Ultimately, we see the lines between utility and oil companies blurring as clean hydrogen, produced by renewable electricity, replaces hydrocarbons in the energy value chain. Both strategic approaches will present opportunities for credit investors, since they typically involve companies with strong credit ratings acquiring weaker ones. Bondholders in target entities will benefit from capital gains as credit risk reduces. However, identifying which targets will be the subject of a bid that increases credit value, rather than one that proves dilutive, will require careful due diligence.
Bond investors must pick their moments
Unlike equities where early entry to broad secular trades captures maximum upside, bond investors tend to benefit from waiting for the investment phase and funding of growth as the trade gathers pace. Leverage tends to peak and spreads to be at their widest (due to elevated levels of bond issuance) when a company is investing in new business opportunities that have yet to generate strong cashflows. This creates attractive entry points for investors who believe the market’s perception of a company’s risk will prove to be incorrect.
We may therefore prefer to take an underweight position in certain sectors likely to see a big pick-up in bond supply, in anticipation of increasing our holdings as the supply peaks. Other areas will benefit from a lowering of credit risks as stranded asset risks reduce or demand patterns become more predictable. In the context of increased climate-related spending, we are taking a close interest in the following areas where we expect credit dynamics to evolve.
Utilities: The most obvious beneficiary of the AJP will be the utilities sector, given the ambitious Clean Energy Standard designed to deliver carbon free electricity by 2035 and a carbon neutral economy by 2050. The emphasis on ’Clean Energy Standard’ rather than ’Renewable Portfolio Standard’ allows nuclear power generation to be in the mix, as well as wind and solar. This push for clean energy should benefit established renewable developers and nuclear operators, while the tax incentives for 20GW high voltage transmission lines will benefit transmission system operators.
Despite an absence of detail on how the fiscal boost will be implemented, we expect opportunities in the renewable-rich Midwest for companies that are developing clean energy sources and providing grid connectivity. This should also lead to greater electrification overall which, alongside increasing take-up of electric vehicles, could boost investor demand for copper and aluminium producers who supply the raw materials for wires and auto parts.
Clean hydrogen and carbon capture: President Biden’s plan to fund clean hydrogen demonstration plants at existing carbon emitting locations wherever possible should help preserve jobs in those communities and generate bipartisan support in Congress. Industrial gas companies should benefit from greater hydrogen production, while refineries may also prove to be unlikely winners if they can pivot to producing ‘blue’ hydrogen from natural gas, using carbon capture and storage, and receive enhanced tax credits.
Climate resilience: Biden proposes to make the electric grid, food systems and urban infrastructure, including hospitals and transport, more resilient to climate disaster. Buildings will be made more energy efficient with $213bn of funding to "produce, preserve and retrofit" around two million affordable and sustainable homes. A separate sum will be dedicated to building or modernising state-run schools, childcare facilities, hospitals and federal buildings, mainly through improving energy efficiency. This could benefit a broad range of sectors from utilities to building materials to engineering and technology.
Digital inclusion: Access to digital services is also part of the plan. Around $100bn has been earmarked for increasing broadband access for 30 million households, ensuring the whole country can benefit from being online. Congress also recently enacted the CHIPS (Create Helpful Incentives to Produce Semiconductors) America Act, which seeks to incentivise firms to increase domestic semiconductor manufacturing operations at a time of global chip shortages.
These two policy measures imply a range of benefits for US tech firms, though the rollout of 5G and faster broadband will not automatically boost incumbents. Nonetheless, technology remains key to economic growth and the low-carbon transition. In this context, providers of semiconductor equipment and 5G infrastructure and tech suppliers to the clean energy (smart meters, battery walls) and industrial automation (robotics, EVs) sectors may offer potential opportunities.
The size of the green/sustainable bond market looks set to explode under new US political leadership on climate change, and these fiscal measures will bring winners and losers. Working out which firms will benefit and when to invest in them will be central to generating long-term value for bond investors.