Prior to 2013, green bonds were something of a niche market. Since 2013, the green bond market has experienced a significant increase in issuance each year, as well as increased interest from institutional investors.
According to the industry group Climate Bonds Initiative (CBI), green bond issuance has grown from $3 billion in 2012 to a record $81 billion in 2016.
In 2017, CBI expects $150 billion of new issuance. Although green bonds represent a relatively small component of the overall bond market, demand for green bonds as a source of green financing could increase dramatically.
Issuers and investors may have different opinions and interpretations of what they see as necessary criteria for a bond to be considered green. While there’s no universal definition of a green bond at present, consensus has begun to emerge.
Today, the market generally regards a bond as green if the issuer uses a bond’s proceeds to finance a project or process that generates climate or other environmental benefits.
Such projects or processes could include, but are certainly not restricted to, solar and wind power generation, sustainable water management or clean transport options.
Green bonds can be issued by governments, government agencies, corporations or any other entity looking to finance projects that intend to generate direct benefits to the environment.
Investors must conduct their own research to determine whether a bond meets their green requirements. There is no central regulator or authority on green bond issuance.
Up until 2014, these decisions were based solely on information supplied by the issuer regarding the ‘green aspirations’ of the bond being issued. As the green bond market developed, this reliance on issuer declaration came under closer and closer scrutiny.
Investors realised there was no guarantee that proceeds raised via a green bond would actually benefit the environment.
In an effort to provide greater clarity to investors, the International Capital Market Association (ICMA) developed the Green Bond Principles in 2014. The principles provide issuers with recommended guidelines for a ‘best practice’ standard to follow when bringing green bonds to market.
Bonds verified as meeting the recommendations of the Green Bond Principles by third party certifiers are referred to as ‘labelled’ green bonds. This green label is a signal to investors that a specific bond has been reviewed and deemed to satisfy the relevant Green Bond Principles.
Green bonds most commonly appeal to investors who are actively looking to finance action on climate change mitigation and adaptation. They can help investors meet a broad range of objectives, including both financial and environmental goals.
Despite recent growth in issuance, the size of the green bond market remains small relative to the conventional market. The market value of some of the most widely used green bond benchmarks are currently less than 1 per cent of the Bloomberg Barclays Global Aggregate Index.
Green bond issues tend to be smaller than that of conventional bonds and the purchasers of these bonds tend to be long-term holders looking to satisfy ESG objectives rather than trading for short-term gains.
The concern for investors is whether these factors will increase the cost of green bonds via oversubscription to primary issues and tighter spreads in the secondary market.
To date, the evidence has been mixed. A recent report by HSBC, Performance: Dispelling the Urban Myths, suggests there was little evidence to suggest green bonds come to the market tighter than conventional bonds or that green bonds trade tighter than conventional bonds in the secondary market.
In its March 2017 report Green Bond Pricing in the Primary Market, the CBI suggests anecdotal evidence that green bonds are oversubscribed in the primary market and may price tighter than expected.
While investors need to be alert to the relative value of green bonds versus their conventional counterparts, it should be remembered that these are very early days for the green bond market.
We would expect any imbalance to improve over time as the need for green financing and an influx of new issuers improves market liquidity.
However, investors wanting to gain exposure to green bonds but also looking to minimise the impact of any market imbalance should:
- Ensure the criteria of the investment universe of the benchmark they select are not restrictive in terms of breadth of coverage or liquidity; and
- Consider using a pooled fund product rather than a stand-alone mandate. The use of a pooled fund could provide a more efficient means of gaining exposure to the overall market relative to trying to establish a stand-alone portfolio from scratch.
Also related to pricing, but something that will only become clearer over time, is the issue of what value is placed on the green component of a green bond.
As the market matures, and more investors are drawn into the market due to ESG objectives, investor demand for the green component of a bond may result in upward pressure on green bond prices.
Another potential issue with the cost of green bonds involves the growing reliance on a third party certification process. As the demand for transparency of information increases (e.g. to gain access to market benchmarks), we expect issuers will need to engage with certifiers on an increasing basis.
This increased administration cost could see a narrowing in spreads between green bonds and conventional bonds of similar characteristics.
In the same way the relationship between rating agencies and issuers has come into question, so can the relationship between the green bond certifier and issuer.
It is essential for an investor to understand how a green bond has been certified, by whom and whether this entity is viewed as competent to carry out the process.
Green bonds need to ensure they retain their ‘green’ label. So if there is any significant change to an issuer’s business objectives, the green status of its project or its financial viability, a bond that was purchased green may lose its label, presenting a potential financial loss to the investor.
Projects financed by green bonds still need to be commercially viable. A green label does not guarantee the credit quality of an investment or the payment of regular coupons and principal on maturity.
Accordingly, informed investors will look at both the financial and environmental aspects of a green bond before committing capital.
We see the green bond story playing out over a longer period of time. As the market grows, liquidity will improve.
For investors with a particular focus on sustainability within their investment remit, green bonds provide an opportunity to promote positive environmental change while owning an investment with the potential for a comparable market return.
Investors without an ESG focus should watch this category of the bond market and keep a flexible posture for future participation.
Ross Bolton is a senior fixed income portfolio manager at State Street Global Advisors.
