Green bonds have seen dramatic growth both in terms of market size and media coverage in recent years. In 2019 we saw $237bn of issuance, a 62% increase on 2018’s $146bn, from a mixture of sovereigns, financials and corporates; and in its wake has come a proliferation of dedicated green bond funds.
The purpose of green bonds is to specifically fund environmentally friendly projects by reducing their associated cost of capital.
On the face of it this a simple and positive method of accelerating positive change, but while green bonds certainly appear to work for issuers, do they work for investors? Are the risk-adjusted returns adequate, and do the expected environmental benefits materialise?
We have addressed these questions and others in a whitepaper on green bonds published this week titled ‘Do Green Bonds Work for Investors?’ (to receive a full copy please contact [email protected] ).
In carrying out this research, one of the challenges we identified for this sector concerns transparency around the use of green bond proceeds; there have been cases of funds leaking into the business as a whole, beyond ring-fenced projects. In part this is related to auditing; who (if anyone) monitors the cash deployment and the success or otherwise of the output? Is a company auditing itself, paying a ‘consultant’, or using some other method of tracking its green bond proceeds? In our view, the practical difficulty of isolating specific ‘green’ projects from an issuer’s general financing and overall ESG performance is a huge challenge for the green bond market. What if a company issues a green bond but its overall ESG performance is abysmal?
While this is understandable for a young and developing market, we also noted issues regarding market structure by size, diversity of issuer (the green bond market is dominated by sovereigns) and currency concentration (USD and EUR denominated bonds account for 90% of issuance). While individual green bonds may well have specific characteristics that make them attractive investments, it is clear to us that, historically at least, the asset class overall has struggled to compete with other risk assets on a risk-adjusted returns basis. With less than half the yield, less than half the return, and double the volatility of the US broad investment grade government and corporate bond index, if these trends continue then to us green bonds do not seem attractive from a pure risk-reward perspective, relative to other areas within fixed income.
The good news is that the slimmer yields on offer in the green bond market do show there is substantial capital looking to be invested in projects and companies that take improving their environmental performance seriously. The green bond market is young and is growing rapidly, though in our view its development could be enhanced through agreed market standards and possibly regulation.
For now we believe green bonds do not offer enough advantages for investors, but that individual transactions can and should be judged on their own merits; see BBVA’s inaugural green Additional Tier 1 (AT1) deal, for example.
When looking at the green bond market as a whole, however, we find ourselves returning to a common theme we have highlighted before, namely that the market’s desire for ‘tick box’ rule-based solutions really does not cut it in the world of ESG. In order to truly fulfil investor expectations in this area, we think a more active approach is required; we detail one potential answer to this in another whitepaper, ‘Sustainable Credit: A Free Lunch?’ (again please contact [email protected] ), which suggests there is a more efficient way for investors to achieve positive societal and environmental outcomes without suffering the poor risk-adjusted returns that in our view are associated with green bonds.