The new bonds on the block

The rise of green and sustainable bonds

Since the European Development Bank issued the first green/climate bond in 2007 the segment has witnessed significant growth. In 2019 approximately $260bn-equivalent of green bonds were issued, 51% more than in 2018. Europe was the largest contributor last year making up 45% of global issues followed by Asia and North America. The wave has recently reached the Middle East and Latin America after Saudi Arabia’s Islamic Development Bank and Chile successfully launched green bonds.

The European Central Bank and the European Commission have made large commitments to sustainable finance and the greater emphasis on these initiatives are being met with growing investor demand. With their increased emphasis on sustainability of investment strategies, private clients and family offices, sovereign wealth funds, and mutual funds will look for more supply of these assets.

Increased demand, more complexity

Combining traditional investment goals with impact goals has become an attractive proposition. In fact, both factors (return and impact) should have never been separated in the first place. While the estimated return (to maturity) of a green bond can be derived from the yield relatively easily, there are challenges when trying to measure the degree of the environmental or social impact.

Investors are faced with numerous definitions, different criteria and variations of impact and green bonds: ESG bonds, green bonds, social bonds, sustainability bonds or transition bonds are just a few examples. There is clearly still a need for greater transparency.

What makes a bond green?

“Green bond labelling” is not regulated at this point. Government bodies and associations have already helped to bring more standardisation to the market.

The Green bond principles (GBP) issued by ICMA (International Capital Market Association) in June 2018 or the launch of the new European Union (EU) taxonomy in December 2019 are good examples of the efforts being made. In addition, the bloc’s Technical Expert Group on Sustainable Finance (TEG) proposed an EU Green Bond Standard (EU-GBS) which should contribute to further standardisation and increased transparency.

The GBP defines green, social and sustainability bonds as one where the proceeds will be exclusively applied to eligible environmental and/or social projects. At least 95% of the proceeds must be earmarked for such projects which is often tracked by ongoing reporting by the issuer.

The organisation also defines eligible projects using the taxonomy below as a foundation:

1. Climate change mitigation
2. Climate change adaptation
3. Sustainable use and protection of water and marine resources
4. Transition to a circular economy
5. Pollution prevention and control
6. Protection and restoration of biodiversity and ecosystems.

Creating standards builds trust

Issuers who wish to issue a green bond usually work with the respective syndicate bank using the framework of GBP or others. A second opinion provider, like Sustainalitics or Vigeo, subsequently can verify the green label.

Fifty shades of green

Investors still face various challenges as companies have a degree of freedom in the given frameworks and could use “green washing”. For instance, the issuer could make misleading claims about the environmental profile of the project funded by the respective bond.

Additionally, investors might find themselves in a dilemma when a green bond is issued by a “not so green” or low ESG profile company. Issuers, like traditional energy companies, can use dedicated funding to accelerate the energy transition process but equally to “de-carbonize” their own production process. For instance, the energy used in order to explore oil. This might be in line with some investor’s policy but not for all.

Do green bonds deliver superior returns?

Although there is no evidence that green bonds deliver superior returns compared to conventional bonds, there are some factors that should be considered. Yields or spread premium of bonds are similar to, and in some cases lower than, the yield or spread of conventional bonds. And this should not come as a surprise for the following reason:

While green bonds allocate funds to dedicated projects, the bonds are usually not secured against assets or revenue streams and the investor is ultimately exposed to the same credit risk as holders of conventional bonds. The marginally lower yield of green bonds is a result of the additional demand from dedicated responsible mandates and given the lack of choice of green bonds at this stage.

Responsible issuers should be less exposed

While the credit quality of green bonds relative to conventional ones is the same, issuers who issue green bonds often put a large emphasis on governance and sustainability when defining their overall company strategy. Such an approach should make any debt of respective issuers more resilient and less exposed to adverse scenarios in the long term.

Where can I find green bonds?

Apart from government-sponsored issuers like Fannie Mae or the European Investment Bank, green bonds are mostly concentrated in three sectors: utilities, bank and real estate investment trusts. But telecommunication or technology companies have been among prominent issuers recently using green bonds to fund energy efficient data centres or networks, for example. Meanwhile an increasing number of passive and active funds offer dedicated green or ESG bond strategies.

Green vs ESG-linked bonds

The green bond format is only one type of investment in this evolving market. Another format witnessing increasing investor attention recently are bonds linked to the quality of environmental, social or governance (ESG) practices of the corporation, sometimes called sustainability bonds. This type of bond includes a contingent step up in coupon (say 0.25%) should the respective issuer breach any pre-defined key performance indicator thresholds. These can include specific operating practices such as waste or emissions levels, or to an independent ESG rating for the issuer.

This seems like an attractive proposition for investors wanting to consider the overall ESG performance of an issuer rather than focusing only on one part of the company’s activities. No matter which format will be established in the future it is already clear that investors, issuers and governments are embracing the initiative. After all its about conscious investment decisions.

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