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Climate change poses one of the biggest challenges of the 21st century. Still, fixed income markets lag in their response. The green bond market remains relatively modest in size and many investors are unclear on some of the key characteristics of the instruments. Another crucial question is whether green bonds provide the type of return investors can find in other bond classes. We answer five questions that clients repeatedly ask about the asset class.
Q1. What makes a green bond green?
The criteria for classifying a bond as ‘green’ is derived from three elements:
- The use of the bond issue proceeds.
- The process around the evaluation and selection of the assets.
- The reporting and monitoring on a forward-looking basis of the bonds.
Both the International Capital Markets Association (ICMA) and the Climate Bonds Initiative (CBI) classify green bonds by referring to these points, but each entity has differing degrees of stringency. The CBI also provides taxonomy to issuers to outline common definitions (see below diagram).
Perhaps surprisingly, there is no reference at all to the structure of the green bond ‘host’ (or vehicle), and green bonds have been issued in a variety of formats including senior unsecured, ABS, covered, project, SUKUK and numerous hybrids.
Hybrid bonds are a package that can be used for green bonds. Corporate hybrid bonds are defined by their structural features, where they are usually subordinated, perpetual in nature, and often have coupon mechanisms which allow the issuer to turn off interest payments without defaulting. As such these are often issued by companies who wish to shore up their balance sheets with permanent, quasi-equity capital.
Some investors have doubted whether green bonds can be issued in a hybrid format, citing that the equity-like characteristic of hybrids exposes the green bond to the overall company finances. In hybrids the use of proceeds is incidental; it is the support that the hybrid bonds provide to the balance sheet that is critical to the classification. We see no reason why green bonds cannot be issued in a hybrid security as long as the use of the proceeds is earmarked for qualifying projects and this is verified and tracked on an ex-post basis.
Green bond common definitions
Source: Climate Bonds Initiative, February 2018
Q2. The green bond market is relatively small. Is that a problem?
Although the total green bond market size is smaller than other bond asset classes, issuance has been breaking one record after another. In 2017, the green bond market once again posted a new all-time high with issuance of close to USD 160 billion, an increase of around 60 per cent yoy, according to the Climate Bonds Initiative. The market estimates this growth to continue in 2018 and for years to come, albeit at a lower rate.
Part of what is driving this growth is the gap in investment to reach the two degrees Celsius growth limit as stipulated by the Paris Agreement. The gap is around USD 16 trillion through to 2040, and green bonds are an important instrument used to bridge the funding gap. This should boost green bond supply.
More importantly, the diversification across regions, sectors and instrument types in green bonds continues to improve, with more expected from emerging markets. Some of our sources even suggest the market could reach USD 1 trillion in annual issuance by 2020.
However, it is also important to mention the laggards in green bonds which are the US and UK. While these two countries represent 43 per cent of the global bond universe they only contribute 8 per cent to the total green bond market, based on the Bloomberg Barclays Global Aggregate index. Green bonds as an asset class is certainly viable without these two countries but, if and when they do get more fully involved it will be a big boost to further growth in the market.
Source: Fidelity International, ICE BAML Green Bond Index, February 2018
Q3. Will green bonds protect you from environmental risk?
In short, no. In almost all green bonds, the exposure to environmentally-related credit risks is a function of the entire company's business. Indeed, the sector breakdown of the market suggests that green bonds are more, not less, exposed to environmentally related risks. For example, energy and utilities make up 19 per cent of the global corporate bond universe, while they represent more than 40 per cent of corporate green bonds. Investors need to assess all the underlying risks facing the company including environmental, not just the specific operations financed by the green bonds.
While the concept of stranded assets has been widely accepted, many investors continue to have difficulty with environmental risks. Investors are mispricing environmental risks. Given the asymmetric nature of fixed income returns, where the downside is typically much larger than the upside, sectors which are more vulnerable to environmental risks expose investors to significant downward revaluations.
EDITOR'S NOTE: Stranded assets - assets that suffer unexpected or premature write-downs, primarily due to regulatory changes or technological innovation, e.g. fossil fuel-powered factories facing obsolescence as carbon restrictions are adopted.
Q4. Can green bond returns match conventional bonds?
Given the historically high-quality, high-rated nature of many green bonds, some investors are concerned about whether there are decent spreads available. There is some truth in this. The ICE BAML Green Bond index is comprised of 30 per cent AAAs and around 25 per cent AAs. This compares to the Global Corporate benchmark of 1.2 per cent and around 9 per cent respectively. As a consequence, the option-adjusted spread (OAS) on the green benchmark is 60 basis points (bps), which is some 40 bps lower than on the Global Corporate index.
But this does not mean that green bonds underperform on a quality matched basis. Green bonds in a senior unsecured package frequently price towards the top end of the existing non-green bond price-yield curve, and in some cases trade above it as dedicated green bond buyers drive up prices.
Also, we have seen some recent issues from outside the traditional high-rated, quasi-sovereign issuers and more towards BBB corporates, high yield, emerging markets and even corporate hybrids.
This ongoing diversification of the green bond universe combined with forecasts of USD 140-180 billion in issuance for 2018, mean that constructing a portfolio with risk and return characteristics commensurate with a global credit portfolio is increasingly feasible. Moreover, the dedicated green bond buyer base can provide the securities with consistent demand, resulting in lower volatility in market sell-offs and consequently better risk adjusted returns than the wider bond market.
The overall challenge is building a portfolio of green bonds with sufficient issuer diversification, as well as sector, currency and quality exposures to match the return and risk profile of the broader fixed income market. It is improving but we do need to see a lot more issuance before the asset class can be truly regarded as a core component of a portfolio.
Source: Bloomberg, March 2018
Q5. Where is the next big growth area in fixed income environmental investing?
To date, environmental investing in fixed income has been dominated by green bonds, but we expect low carbon investing approaches to become increasingly prominent. Green bonds will continue to be a key part of environmental solutions but investors could benefit by expanding the universe of issuers to include those with lower carbon intensity.
If investors seek to minimise the carbon intensity of their portfolios they can overcome some of the challenges faced in the green bond market such as the lack of standardisation and promote a more holistic assessment of a company’s environmental activities. A carbon reduction mandate creates a clear, objective target and we can use established carbon-intensity indices developed for equity markets to construct a portfolio which quantifiably reduces carbon production.
We also found that by removing carbon laggards from a global corporate bond index, an investor is left with a sufficiently large universe (66 per cent of the global corporate bond market), which provides a fruitful hunting ground to build portfolios with similar risk and return characteristics to a conventional credit portfolio. This portfolio can then be supplemented with selective investments in green bonds or companies which are transitioning to a more environmentally friendly policy.
Conclusion
Green bonds play a key role in environmentally aware investing in fixed income markets. But the instruments do have important and sometimes counter-intuitive characteristics which investors should become familiar with. Low carbon investing can provide many benefits for ESG investors and complement an investment in green bonds for better overall outcomes.
A client's view
Watch Naoki Akiyama, General Manager of Japan's Nippon Life Insurance Company, discuss green bonds and his approach to ESG more generally:
