The emergence of green bonds presents an attractive sustainable vehicle for fixed income investors, though not without drawbacks. The potential value of green bonds is obvious from the name; the securities prioritize the importance of environmental concerns as a means of either reducing risk or forming a competitive advantage when using the proceeds from the sale of the note. Green bonds also send the market a positive signal about their issuers’ intentions and priorities.
Although green bonds have begun to blossom as an asset class, with impressive growth since they first appeared in 2008, the size of the asset class is still that of a tiny sprout relative to the total bond market (European Commission, 2016). Green bonds make up just 0.13 percent of fixed-income assets under management worldwide. This figure will likely grow, as institutional and retail investor demand for fixed-income investments that consider environmental, social and governance (ESG) factors remains in the early stages. Investors only broadly familiar with ESG investing need to account for idiosyncrasies in green bonds’ structures, ratings, geographic makeup, and ultimately, performance before allocating to this budding asset class.
Since 2008 when green bonds were born from a limited public-private experiment, they have experienced a strong rate of growth. According to the Climate Bonds Initiative, in 2017 a record $155.5 billion of green bonds were issued, up from $87.2 billion the year before, representing 78 percent year-on-year growth (Nina Chestney, Reuters, 2018). Unsurprisingly, as the rate and diversity of green bond issuance has grown, the characteristics of green bonds have come under greater scrutiny within the ESG community. Essentially the question comes down to, "How green is green?"
Green bond issuers aspire to meet voluntary standards and principles, but ultimately green bonds are not regulated or subject to a formal compliance process on their "green" status. Currently, the Green Bond Principles and the Climate Bonds Standards are the main international frameworks employed to label green bonds, but compliance is neither screened nor ensured by any one authoritative third party.
Ambiguous issuing guidelines are only one reason for investors to look before they leap. Reviewing green bonds’ performance reveals additional reasons to be cautious.
Green bond performance rests on the issuer satisfying two essential criteria: 1) maintaining fiscal health and 2) retaining "green proceeds" status. While these two criteria may seem straightforward, green bonds come from such a wide variety of global issuers that their solvency can come under question. An equally important dynamic is the risk of a green bond losing its status as a green issue, also known as "falling from green grace."
While the green status of a bond may at first seem superficial, the severity of the loss of green issue status can be meaningful, especially considering that research has shown green bonds can command higher prices relative to non-green bonds as a result of greater investor demand. A 2017 academic study concluded that, on average, green bonds are more liquid relative to conventional bonds and trade at a premium in the secondary market (Wulandari, F. C., Schäfer, D., Stephan, A, & Sun, 2017). A similar academic study found the effect of green bonds' higher liquidity on yield spreads to be pronounced, with green bonds commanding 10 times the premium of speculative German bonds and 100 times the premium of investment-grade US corporate bonds (Sun, C., & Wulandari, F. C., 2017).
When it comes to the important question of performance, even greater attention is needed to find the budding flowers among the weeds. For example, when comparing green bond indices, such as those provided by S&P and Barclays MSCI, to their respective conventional counterparts, we find not only relative underperformance over a three-year period but also considerable variability with regard to fixed income benchmarks. For a bond to be included in the index, the bond issuer must explicitly disclose the use of proceeds; otherwise, its compliance with the Green Bond Principles must be independently verified.
How do we explain the disparity in returns among these indices, especially when numerous studies indicate compatibility between sustainable investing and competitive returns?
First, part of the answer has to do with index composition. Prior to 2015, most green bond issuers were primarily government-sponsored or supranational entities offering a lower yield consistent with their stellar credit ratings. In addition, many of these issues were non-U.S. dollar denominated securities during a period of dollar strength.