Conspicuous by its absence over a number of years, Brazil has finally come round to joining Latin America’s expanding sustainable bond market. By Ben Edwards.
Latin America’s green, social and sustainable sovereign bond market has been growing at a rapid clip over the past five years, rising from just US$2.4bn in 2019 to US$19.2bn in the first half of 2023 alone, according to Climate Bonds Initiative data. Yet one country had been conspicuous by its absence during that period: Brazil.
The region’s largest economy – home to about 60% of the Amazon rainforest and where more than a quarter of its population are estimated to live in poverty – might have seemed an ideal candidate for this type of debt. But while others around them have been eager to tap the market, Brazil remained firmly on the sidelines. Then, in November last year, Brazil finally pulled the trigger on its debut sustainable bond.
"It was really important that Brazil issued – it’s the largest LatAm economy, it’s pretty pivotal to regional politics, and also quite a few of the largest companies in the region are domiciled there, so it was important signalling for the whole market," said Joe Horrocks-Taylor, a responsible investment analyst at Columbia Threadneedle Investments.
Brazil’s debut in the sustainable bond market saw it issue a US$2bn seven-year transaction that was priced to yield 6.5%. The sovereign said its bond attracted almost US$6bn in demand, with roughly 75% of orders coming from Europe and North America and the rest from Latin America. About 60% of the buyers were asset managers, including dedicated ESG funds, suggesting a more patient investor base.
"The attraction to longer-term bondholders means sustainable bonds tend to behave better than conventional bonds because they are not being bought by speculative investors," said Esther Law, a senior portfolio manager for emerging market debt at Amundi.
There are several reasons why Brazil was slower to issue than other countries in the region. For starters, the political backdrop under previous president Jair Bolsonaro was seemingly less concerned with environmental issues. For instance, Bolsonaro cut the enforcement budget of Ibama – Brazil’s Institute of Environment and Renewable Natural Resources – making it harder for the agency to combat deforestation.
"The moment Lula came back in and pitched his sweeping green transition plan as a centrepiece of his government, the conversation about green bonds was high on the agenda," said Barbara Oldani, stakeholder engagement lead at the Sustainability-Linked Sovereign Debt Hub.
Aside from politics, putting together a sustainable bond framework can take time. The country also needed to demonstrate progress on deforestation rates and that it was properly tackling illegal logging in the Amazon.
"There were internal technical issues such as things like taxonomy development, budget tagging and project pipeline," said Horrocks-Taylor. "But there was also a wider market reception issue as well – investors aren’t going to pay a premium for a green bond if deforestation is rising as it was under Bolsonaro."
In addition, Brazil is a less frequent visitor to international capital markets than some of its peers in the region, meaning there was not as much pressure to issue.
"Brazil doesn’t have such dependence on external funding and therefore the incentives for them to create the conditions to issue a green bond were lower than for some other countries in the region," said Rodolfo Luzio, head of emerging market debt sovereign research at MFS Investment Management.
More pressing need
The introduction of Lula’s green transition plan, however, means there is now a more pressing need for Brazil to issue. Among those plans include a target to reduce greenhouse gas emissions by 53% by 2030 and achieve net zero by 2050. The World Bank estimates the cost of meeting those targets will be US$1.4trn between 2016 and 2030.
While there was initially a wave of optimism about Lula’s green agenda, that has been tempered by political opposition in congress.
"There has been a bit of a reality check in terms of how much Lula can actually push his environmental agenda given the way congress is currently split," said Horrocks-Taylor. "The balance of power in congress really is quite weighted against Lula, and that’s why we’ve seen some of his initial measures being rolled back."
That has included moving some of the power he gave to the Ministry of Environment back to the Ministry of Planning, which is potentially negative for deforestation control, said Horrocks-Taylor. Much of this is being driven by Brazil’s agricultural caucus, which is pushing back against Lula’s green agenda and holds significant sway across all political blocs.
"Part of it is a tool to degrade Lula but part of it is also just the strength of agricultural influence in Brazil, and any measure that seeks to curb that influence in the country is likely to get pushed back," said Horrocks-Taylor. "Lula’s agenda so far has been quite stick-heavy on controlling deforestation driven by agricultural expansion, with a paucity of carrots. That’s now what he’s trying to solve."
The proceeds from Brazil’s debut sustainable bond deal will be split roughly 50/50 between green and social spending, with a slight weighting in favour of environmental projects. At least 75% will go towards financing new expenses, the finance ministry said. Some of those projects include deforestation control, biodiversity conservation, the country’s National Climate Change Fund and poverty-reduction initiatives such as Bolsa Familia and its food acquisition programme.
While the bond was generally well received, investors say there is room for improvement on any future deals.
"Some of the inherent challenges we had with the bond structure is it’s very broad as there are 17 eligible categories," said Patrick O’Connell, director of fixed-income responsible investing research at AllianceBernstein, which bought some of the bonds.
“It’s understandable that they give themselves a lot of categories, but that makes it more tricky as an investor sitting thousands of miles away in a glass building to understand where the money is actually going."
Investors will have to wait until later this year to see where the proceeds from the debut bond have actually gone and to gauge its impact.
"It’s going to be hard to quantify some of the impacts of the eligible categories like Bolsa Familia and whether an extra billion or so US dollars will really move the needle on a huge programme like that," said O’Connell.
SLB possibility
One potential way to show more direct impact is through a sustainability-linked bond, he said. For example, preserving the Amazon rainforest is top of mind for international investors, which would make it ideally suited for an SLB transaction.
"They have really good tracking using satellite information on deforestation, so why not do a sustainability-linked bond tied to the deforestation rate? That’s something international investors care about, and you can measure your degree of ambition,” said O’Connell. "And it’s an objective measure – satellites don’t lie; it’s either this number or that number."
Despite getting its first deal away, Brazil is not expected to be in a rush to load up on more green debt.
"They want to source projects for the use of proceeds first before issuing more green or sustainable bonds," said Law.
That could potentially pave the way for sustainability-linked issuance, given that the proceeds can be used for general budgetary purposes, unlike traditional green or sustainable bonds.
"By issuing their sustainable bond, they have done a lot of the groundwork that would enable them to issue a sustainability-linked bond in future," said Oldani. "Lula’s transition plan covers some major areas which are very much linkable to KPIs and could easily be embedded into an SLB."
This approach has already been pioneered by regional peers including Chile and Uruguay, which have issued this type of debt as a way to advance their green agendas and ensure they maintain progress.
"They clearly wanted to send a signal about how committed they are to specific targets and being held accountable to achieving those by putting some skin in the game and facing potential penalties such as coupon step-ups if they don’t meet the targets, or as in the case of Uruguay, a coupon step-down if they do meet the target," said Luzio. "This is how you really focus minds and create conditions for making an impact."
While investors expect the market to continue growing over the long term, issuance is likely to be more muted this year given the broader interest rate environment, with only a handful of deals seen in the first half of 2024.
Chile, for instance, issued a US$1.75bn social bond in January and tapped it again in May while also issuing a new social bond, raising about US$2.15bn. Meantime, Mexico issued a €2bn bond linked to the UN’s Sustainable Development Goals in January – its fifth such deal since 2020. And Colombia also reopened its 2035 and 2053 social bonds in April, raising US$1.3bn.
"Higher rates in the US is just making it a bit more tricky for fixed-income issuers in general," said Law. "For the higher-yielding issuers, the cost of funding is still relatively high, so we may see a bit of a slower comeback in issuance. We may see some more in the September window, but it will also depend on the pipeline of sustainable projects for those countries on whether they do a sustainable bond or a conventional bond."
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