In addition, the market now offers social bonds and sustainability bonds. These bonds are extensions of the green bond market. Social bonds signal that bond proceeds are financing social purposes, while sustainability bonds finance both social and environmental projects. The development of these new classes of bonds illustrates rising interest in fixed income investing that provides capital to beneficial projects.
All That Glitters Isn’t Green
We think green bond growth and other signs of the sustainable investing conviction are certainly encouraging, and new green bonds can often highlight opportunities for investments with solid long-term credit profiles. However, we believe that investors should maintain a balanced perspective on green bonds, as the green bond market is still in its early stages and the discussions about proper labeling are still ongoing.
Eligibility Standards Still Hazy. To begin with, the discussion of what exactly qualifies as a “green bond” is unfinished. Many issuers and borrowers rely on the Green Bond Principles (GBP), criteria created by a consortium of investment banks in 2014. The GBP are process guidelines for green bond issuance with four core components: Use of Proceeds, Process for Project Evaluation and Selection, Management of Proceeds and Reporting. However, the GBP are voluntary guidelines for issuers.
For climate-related bonds, the Climate Bonds Initiative (CBI) generated the “Climate Bonds Standard and Certification Scheme,” which uses rigorous scientific criteria to ensure that “Climate Bonds Certified Bonds” are consistent with the 2 degrees Celsius warming limit in the Paris Agreement (see Fossil-Fuel-Free Investing: Process and Perspective). Many rely on CBI certification to determine labeling. However, CBI certification is voluntary as well.
Some third-party research firms, such as Sustainalytics, perform green bond assessments. Or, in some cases, funds and issuers have crafted their own definitions and standards of green bonds.3
With this lack of standardization, investors do not have an implicit understanding of the criteria green bonds must satisfy, nor a sense of how green bond proceeds will be used to fulfill their green initiatives. Broad-based adoption of a certifying scheme is an important component of the future of the green bond market. Standardization will help investors to better evaluate and monitor the bonds and to have more confidence that the issuance adequately provides corollary benefits.
History Still Limited. History surrounding green bonds is still fairly recent, as the first green bond was issued in 2007,4 and the first U.S. municipal green bond was issued only five years ago.5 While growth in the green bond market has been strong, the size of the global market ($221 billion)6 pales in comparison to the overall U.S. fixed income market ($41 trillion),7 and research into green bond pricing and credit trends is hindered by a shorter time horizon and smaller sample size versus traditional bonds.
Credit, Pricing Impacts Unclear. Many market participants have conducted research on the potential premium required to purchase a green bond versus a traditional bond, particularly given the oversubscription often afforded by green bonds in the primary market. Results have been inconclusive. Barclays research found that green bonds traded 17 basis points (bps) tighter in option-adjusted spread than traditional bonds, as of mid-2015.8 That Barclays research also showed that the premium had steadily increased from early 2014 through late 2015. A different 15-month sample from the Climate Bonds Initiative of more than 60 investment grade bonds also showed evidence of a premium. U.S. dollar corporate green bonds priced on average 22.2bps tighter than Initial Price Talk,9 versus 16bps to 17bps tigher for traditional bonds. However, in that report, some green bonds priced in line with their existing credit curves, while others priced with a tighter or wider spread than expected. In addition, euro corporate green bonds priced within range of traditional bonds.10 Also, in a report specifically focused on muni green bonds, no premium was evident, per Barclays.11
As for green bonds’ place in the capital structure, typically, they rank in line with existing debt of the same seniority and there is no credit enhancement.
These mixed credit and pricing trends for green bonds support our view that prudent green bond investing should include an in-depth evaluation of the risk and return profile of each green bond, considering bond structure and idiosyncratic risks.
Green Bonds Offer Many Positives, But Research Beyond the Label Is Important
Investors can combat these issues and beat fatigue with potential “green washing”12 by performing the same bottom-up credit research process with green bonds that is used in traditional bond investing. Breckinridge regularly reviews green bonds when they come to market, but investments are only made when they meet our standards for structure, pricing and credit quality, among other considerations.13 All green bonds are subject to the same research and investment process that is applied to all our investments. While green bond labeling is largely based on how the bond proceeds will be used, at Breckinridge, we believe that sustainable investing requires looking beyond the use of proceeds. To establish a full picture of an issuer’s sustainable characteristics, it is important to look at each issuer’s ESG profile, as ESG can impact credit fundamentals (see: Looking Beyond Use of Proceeds). Although we appreciate that most green bonds offer transparent reporting and back important sustainable projects, Breckinridge will not forgo return or “pay up” to invest in a green bond.
As green bonds continue to gain traction with investors and issuance spreads across a more global and diversified range of borrowers, more stringent evaluation standards will likely be necessary. Stricter standards will help investors have more confidence that they are investing in a green bond that is truly sustainable, and it could also provide more recourse against green bond issuers that drift away from their green mandates. Still, Breckinridge advocates researching green bonds closely.
Green Bonds Are One of Many Paths to Sustainable Fixed Income Investing
We believe ESG metrics are a powerful tool for managing risks in fixed income portfolios and can help investors better achieve their goals of preserving capital and building sustainable sources of income. In some cases, investors are interested in ESG to align their investing with their values. Investors will vary in their goals and interests in ESG, so their approaches to ESG will vary as well. Importantly, green bonds are just one avenue to sustainable investing. We encourage investors to discuss ESG options with their advisors and to take care in determining the most appropriate ESG approach.