For fund distributors and professional investors only.
Author: Julien Bras, SRI Fixed Income Portfolio Manager
Although the green bonds market has existed for more than 10 years, it still triggers much debate. Some of the questions are fully justified, whereas others now seem to have been answered. This is particularly the case regarding the definition of green bonds and, more broadly, what defines a green project or business. As we hoped, a regulatory definition is currently being established. The final definition is expected to be very close to current market practices, i.e. covering projects that comply with the green bond principles and are deemed eligible based on a relatively consensual classification similar to the existing ones. The new regulatory definition will answer a number of questions and should, above all, open fresh development opportunities in this market. First, there will be opportunities for investors, who will see their investment allocation possibilities broaden to include green solutions. As a result they will be able to participate more actively in the reallocation of their heavily carbonated investments towards a low-carbon economy. Second, the public authorities will have a clearly-defined financial instrument at their disposal which they will be able to associate with mechanisms designed to incentivise issuers. Whatever type of incentive is deployed, it can be used as leverage for the development of further green bond issues, implying a greater number of green financing projects. Last, and most importantly, it will make it easier for issuers to identify projects considered eligible for green financing. This will help corporates and more specifically industrial groups, which are relatively inactive in this segment. This will enable them to tap this market more easily, without fearing a negative reaction because of the selection of a non-consensual project. Given the heavy environmental impact of industries in general, this will provide a key step towards complying with 2-degree scenario targets. This point raises questions: which issuers will be legitimate in using the green bond market for securing funding? Are certain industries or sectors automatically excluded? Will only the companies with the best current environmental track record be able to issue green bonds? If the goal is to reward best practices, yes, there is no doubt that this will be the case. However, if the goal is to promote transition to low-carbon models, then access to this market should be open to as many issuers possible. Although access must not be granted at any price or without conditions, if a company with a heavy environmental footprint is striving towards a credible and ambitious transition strategy to reduce its environmental impact, it must be given encouragement and support.
Gauging environmental impact is the other key area that needs to be developed almost from scratch. Claiming that a given investment will have a positive impact on energy and climate transition is not enough. The impact has to be demonstrated, or even better, quantified. Although there is a broad consensus regarding the most relevant indicators, notably calculating CO₂ emissions avoided, there appears to be no single indicator applicable to all types of projects and in all contexts. A multifaceted impact assessment is therefore needed, which is not a complicated issue. However, although detailed indicators are required, focusing on data should not eclipse the key investment rationale, namely the participation in financing a transition towards reduced-carbon models. In certain cases therefore the qualitative assessment of an investment will perhaps be more relevant than striving to define a standardised indicator. The relevance of an investment aiming to preserve and restore the biosphere of oceans, which are carbon sinks or the value of a reforestation project in an over-exploited region, cannot be denied. How many tonnes of CO₂ emissions have been avoided? Is this really what counts? Not all examples are as simple to gauge, and although the impact of some industries can easily be measured, a different rationale will be required to account for those necessary investment choices whose impact may not be quantifiable. Investments in development solutions, particularly industrial projects, are a good example. Some projects, without necessarily having a direct positive impact, or perhaps even negative, will nonetheless promote transition towards a lower carbon model and will not have to be ignored. Let's not lose sight of our initial aim: promoting a sustainable future for our economy.
While green bond issuance is expected to increase globally, the asset class has not yet made it into most investors’ fixed-income allocations. But green bonds might prove complementary in fixed-income portfolios – most likely in place of global aggregate and US aggregate allocations – as investors recognise the need for an urgent transition towards a more sustainable economy.
Key takeaways:
Green bonds’ popularity is growing quickly. In 2018, against a backdrop of a global fall in overall bond issuance, green bond issuance increased. According to data from the Climate Bonds Initiative (CBI), more than USD 168 billion of new green bond issues worldwide came to market last year.
Issuance levels could well reach a new record of USD 200 billion during 2019, taking into account the strong first half of the year, the potential for further large sovereign green bond issues and developing market standardisation and regulation. Total global green bond issuance since the inception of the asset class had reached USD 600 billion at the end of Q2 2019, driven by burgeoning investor appetite.
While 20% of the green bonds issued in 2018 originated in the US, investors there have so far been more cautious than their European counterparts, and proven more reluctant to add green bonds to their fixed-income portfolios. We believe this caution is unfounded though. Green bonds show similar risk and performance patterns to global aggregate and US aggregate, while offering additional potential for diversification and helping to meet some big environmental challenges. Green bonds are well placed to become a key financial instrument in what this year’s PRI in Person conference called “an age of urgent transition”.
The International Capital Markets Association defines green bonds as “any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible green projects and which are aligned with the four core components of the Green Bond Principles.”
Those four principles ensure that the bond is structured in a format which complies with the basic set of requirements most market participants want to see:
The use of proceeds detail distinguishes green bonds from regular bonds. To qualify as a green bond, proceeds must support environmentally friendly projects, while for regular bonds any activity of the issuer can be financed. In addition to evaluating the standard financial characteristics – like coupon, maturity, or credit quality of the issuer – investors in green bonds also assess the specific environmental purpose of the projects that the bonds will finance. Green bonds are therefore financial products which bring investors:
Investing in a green bond does not cost any more than investing in the same issuer’s conventional debt with comparable maturity, coupon, and seniority. There is currently no material difference in pricing or liquidity between green and standard bonds. When you invest in a green bond, the risk is the same as when you invest in a conventional bond – ie, the risk of the issuer – rather than the projects to be financed by the proceeds.
We analysed data from a set of Bloomberg Barclays indices representing green bonds, global aggregate and US aggregate and found that the three asset classes – while very similar in terms of correlation – show different patterns when it comes to performance and interest rate sensitivity.
Correlation is a measure of how two assets move in relation to each other. A perfect negative correlation of -1 means that when one asset moves, the other moves in the opposite way. A perfect positive correlation of +1 indicates that both assets move the same direction. A correlation of 0 means that there is no relationship at all between asset movements.
We measured the correlation between the returns of three fixed income indices over five years. As the figures in in Chart 1 show, global green bonds are, as discussed in the article “Building the case for Green Bonds”, highly correlated with global aggregate, with a correlation of 0.96% – even higher than the correlation between global aggregate and US aggregate. Green bonds are also highly correlated to US Aggregate at 0.89%.
Having witnessed this strong correlation, we looked at how it was reflected in the past performance and volatility of the three asset classes over the last five years. The idea was to measure the risk/return profile of each asset class in order to determine whether green bonds outperformed or underperformed global or US aggregate, and why.
Charts 2 and 3 demonstrate that, over this period, the Global Green Bond index outperformed the Global Aggregate and US Aggregate indices with a volatility comparable to the Global Aggregate and lower than the US Aggregate index.
This means investing with an environmental purpose did not cost performance in the selected period; it has even enabled green bond investors to outperform traditional bonds.
If green bonds’ performance is not materially different to that of standard bonds, the return discrepancies between the three investment-grade fixed-income asset classes could be explained by the different structures of each market. Understanding the main structural divergences can help us understand the potential diversification benefits that green bonds can bring, either to global or US agg.
While all three asset classes can be described as fixed-income, investment-grade, and aggregate – meaning they include all segments of the fixed-income market – there are key distinctions in terms of characteristics and composition between the three markets. Note that both the Green Bond and US Aggregate indices are sub-segments of the broader Global Aggregate index.
The green bond market is younger than the other two asset classes, with the first green bond issued in 2007 by the European Investment Bank. Despite a higher issuance rate since then, this market has remained smaller than the US and global agg in terms of total number of securities and market value, as chart 4 shows. Regarding duration – a measure of interest rate sensitivity – the Global Green Bond index is more sensitive to interest rate changes than the two other indices.
The yield of the Global Green Bond index appears to be lower, mostly due to its higher portion of lower-yielding EUR-denominated debt (see Chart 5 below). The Global Aggregate and Global Green Bond indices are diversified from a currency standpoint, with different currency exposures. While the Global Green Bond index is more exposed to EUR-denominated debt (over 65%), the Global Agg index is more focused on USD-denominated bonds (45%) and also has a higher exposure to Japanese yen-denominated bonds (16%), well above the Yen’s representation in the Green Bond index (0.2%). Chart 5 Currency breakdown of the Global Agg, US Agg and Global Green Bond indices (Top 10 in the Green Bond index).
Both the US and Global Agg are exposed to the Treasury sector (debt issued by central governments in their native currency), but this is less the case for the Global Green Bond index, which might provide potential for some diversification when government bond prices drop, in particular US treasuries. US government debt represents 17% of the Global Agg index and 40% of the US Agg.
The green bond market is more concentrated on government-related issuers (mostly agencies and supranationals) and corporates, with more exposure to financial institutions and utilities than in the US and Global Agg, but with fewer industrials, which have so far been less likely to issue green bonds. The green bond market is also far less exposed to securitised debt (mortgage-backed securities, covered, asset-backed securities, commercial mortgage-backed securities) than the US and Global Agg indices.
To sum up, green bonds as an asset class are highly correlated to global aggregate and strongly correlated to US aggregate. And over the past five years, the Green Bond index has outperformed, showing a marginally higher level of volatility than the Global Agg, but with lower volatility than the US Agg.
As a fixed-income, aggregate, and relatively long-duration asset class, green bonds can complement core bonds in a global or US fixed-income allocation, as they provide diversification without distorting the profile of the overall portfolio. Adding green bonds to a fixed-income portfolio also boosts exposure to bonds from entities which have already started to include exposure to climate change and carbon risk in their business profile. Those entities – corporates, agencies, supranationals or governments – might have some competitive edge in the future as pioneers of the transition towards a low-carbon economic model. It is the major structural disparities between indices that highlight the added value of green bonds, not just as an add-on to a core fixed-income portfolio but also as a stand-alone asset class.
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