Circular economy: An opportunity for fixed income investors

This World Earth Day, RBC BlueBay Investment Grade Fixed Income Portfolio Manager, Harrison Hill reflects on the investment potential for fixed income within a circular economy.

Discussions around sustainable finance often centre around private equity and venture capital, however, fixed income has an equally large part to play. However, to-date this asset class has been arguably underutilised within this space.

The concept of a ‘circular economy’ is rising in prominence as the impact of climate change and resource scarcity increasingly pose risks around the globe.

For investors, this concept represents an opportunity to gain an exposure to sustainable business models that can potentially lead to reduced costs, improved efficiencies, and reduced dependence on finite resources. Despite this, investment in the circular economy from a private sector standpoint remain subdued despite a growing arsenal of ways to invest within the space.

The rise of green bonds

Awareness of ‘green bonds’ has risen over the past decade. These are securities that channel capital toward environmentally focused projects. However, nearly 60%¹ of green bonds are issued with use of proceeds (UoP) targeting – what we would argue is – the low hanging fruit of ‘Renewable Energy’, ‘Clean Transport’ and ‘Green Buildings’. While there is no doubting that these are important activities that do require funding, there is a significant funding gap between those categories and the circular economy, which to-date has received only 1.2% of funding available². While the reasons for this are varied and complex, this number is comparatively low, and we believe represents a substantial challenge for the investing community in the coming years.

Green bonds that have specific UoPs promoting reuse, repair, and recycling are on the rise, but are still incredibly rare. Cumulatively, 7.5%³ of all Green, Social, & Sustainable (GSS) bond frameworks target circular economy projects in their frameworks. When looking at actual allocation of proceeds this number goes down to the 1.2%.⁴

Bonds issued in structures like this allow fixed income investors to buy into issuances knowing that the proceeds will finance the circular economy. UoP bonds offer an attractive method for investors to target their investments to supporting sustainability while still achieving a market standard return and reducing risk. These bonds are in the standard fixed income indices and represent the most liquid avenue to direct investments towards the circular economy within fixed income. However, opportunities are limited given low levels of issuance targeted towards circularity.

To-date, cumulatively, the vast majority of issuers that have allocated towards enabling the circular economy hail from manufacturing sectors. This makes sense as they can incorporate circular targets with their core business activities including reclamation of used materials, recycling of used products, repackaging / repurposing. Some manufacturers naturally align to setting targets aligned with the circular economy as they continuously invest and innovate to make their operations more circular. At the same time, we are witnessing a shift in customers are demanding that products and packaging need to be more recyclable, truly recycled and made from renewable sources so it behoves manufacturers to get ahead of this mega trend.

Issuance of this kind is still low, but comparatively high for manufacturing compared to other sectors.

For example, Financials could issue debt with the sole UoP of allocating capital towards innovative companies that align with circular economy principles. Utilities could issue debt focusing on resource recovery capturing and repurposing heat generated by core activities and/or water used to minimise their waste footprints and reduce consumption of raw materials.

What about sustainability-linked bonds?

Sustainability-Linked bonds (SLBs) are instruments that change structure depending on an issuer meeting certain pre-defined sustainability targets. Unlike UoP bonds which fund specific projects SLBs don’t require allocation reports, the proceeds can go to whatever business activity the company chooses, but should the company fail to get to the pre-determined targets then there is usually a financial penalty that bondholders would receive as recompense.

A good example of a KPI specifically targeting circularity comes from a glass bottle manufacturer who have set a target of reaching an external cullet usage rate of 66% by 2030.⁵ External cullet is glass that has been used by consumers and brought back via recycling programs. By increasing use of external cullet, the company is encouraging a wide range of activities raising awareness on the importance of glass recycling, improving recycling capacities and efficiencies, and optimising cullet usage in production. While the actual use of the invested capital is less visible through this method, being able to track progress towards a sustainability target is a neat way to identify opportunities in this space, as well as reduce future risk.

Provided the targets are ambitious enough this is a win-win for investors, either the KPI is met, and the company has managed to position itself for a circular economy or the investor gets an increased financial return. This sort of vehicle may be more useful for a company that is in transition and is looking to become more circular but doesn’t necessarily have projects that are circular in nature to pin UoPs to.

Debt-for-nature swaps, biodiversity credits and more

Other innovative funding solutions are starting to permeate the fixed income market and, while take up has been limited so far, outcomes-based funding structures, biodiversity credits, and debt-for-nature swaps all offer more entry points for the private sector to invest.

Currently only 17%⁶ of global nature-based solutions comes from the private sector. To make these new innovating solutions a practical investment option, financial services providers, pension funds, and asset managers will each need to have a say during the development phase in this range of assets.

Key issues at the moment revolve around lack of investor take up due to lack of standardisation in deal structures, limited liquidity, principal protection concerns, and uncertainty over payouts both back to investors but also to the conservation activity.

The influence of regulation

Outside of investment vehicles, the regulatory landscape is also creating an environment more supportive of a circular economy – and, in turn, cultivating a more attractive asset class for investors to capitalise upon.

For starters, we are seeing action being taken at the policy level. In England, for example, the adoption of the Circular Economy Package (CEP) introduces new laws, which will aim to reduce waste by promoting resource efficiency.⁷ There is also new legislation that forces builders to contribute to positive improvements in natural ecosystems for new projects undertaken.⁸

The European Green Deal has also positioned enabling a circular economy as a priority policy topic targeting reducing resource use, enhancing sustainable growth, and achieving climate neutrality by 2050.⁹ There is also a movement towards becoming biodiversity champions for a growing number of private sector companies as the private sector begins to recognise the importance of addressing biodiversity loss and impacts on nature. Recognizing the risks, opportunities, dependencies and impacts on nature, over 300 companies have embraced the Task Force on Nature-related Financial Disclosures (TNFD) recommendations¹⁰, integrating nature-centric disclosure into their corporate reporting. The extra disclosures required by the TNFD should also provide a clearer picture of private funds being allocated towards nature and circularity.

Benefits from a traditional corporate bond perspective

From a top level, corporations can benefit from embracing circularity proactively as it can lead to innovation in product design and service delivery, creating a competitive edge and opening up new markets.

By adopting circular practices, companies can reduce waste and operating costs, while enhancing long-term sustainability and profitability. Furthermore, authentic circular business models tend to result in positive brand differentiation and customer loyalty as many consumers continue to pivot towards valuing environmental responsibility.¹¹

To-date there has been a lack of issuance directed towards this theme, which is something there is significant capacity for given the size of the fixed income market and the ability to utilise various structures to bring deals.

What does this ultimately mean for investors?

As we mark World Earth Day, it gives us the chance to reflect upon the potential investment opportunity a circular economy represents. By investing towards circularity, investors have the potential to not only secure higher risk adjusted returns but also lower default risks¹² compared to traditional investments.

The fixed income market is set up and ready to enable corporations to finance their transitions to more circular business models.

^{1 MainStreet Partners, Q3 2023
2 MainStreet Partners, Q3 2023
3 MainStreet Partners, Q3 2023
4 MainStreet Partners, Q3 2023
5 Verallia, CSR Report, 2021
6 MainStreet Partners, Q3 2023
7 Circular Economy Package policy statement, GOV.UK
8 How innovation can save the world’s remaining biodiversity, World Economic Forum
9 The European Green Deal, European Commission
10 TNFD Early Adopters, Taskforce on Nature-related Financial Disclosures
11 The Role of Sustainability in Brand Differentiation, Centric
12 Financing the circular economy, The Ellen MacwArthur Foundation}