Is the green bond market about to take off?, November 2021

Green is definitely the new black. Having barely registered on a bar chart a decade ago, there are more than $300 billion green bonds in issuance today.

In September this year, the UK entered the green gilt market for the first time, when the government issued its first green bond. Fund managers poured in it, with the government raising £10 bn - the largest inaugural green issuance by any sovereign. More green gilts and green corporate bonds are expected.

And, just last week at the COP 26 summit, Janet Yellen, the US secretary of the treasury, announced that the United States would join Britain in backing the Climate Investment Funds' (CIF) new Capital Market Mechanism that will issue investment-grade bonds and raise significant new finance for scaling clean energy and sustainable infrastructure in emerging economies.

"The climate crisis is already here,” she told the conference. “This is not a challenge for future generations, but one we must confront today. Rising to this challenge will require the wholesale transformation of our carbon-intensive economies."

Bryn Jones, lead manager of the Rathbone Ethical Bond fund, who has been lobbying the Debt Management Office for the past ten years for the issuance of green gilts, participated in the UK issuance, adding exposure to government bonds in the fund for the first time.  
He said: "The issuance is a positive initial signal, and it shows that the UK is on the right path, joining other countries issuing green bonds. We have included the green gilts in the portfolio to manage duration and liquidity, whilst providing vital financing to future growth of the green economy and supporting the race to net zero carbon emissions. 
“We expect this year's bonds to encourage more companies to start issuing green bonds as they recognise the strong demand for such securities. This should help broaden our opportunity set in sterling issuance.”  
So, what are green bonds exactly and are they good investments?

Green government bonds: the promise and the pitfalls

Green bonds are issued by governments and companies specifically to fund new and existing projects with environmental benefits – such as renewable energy and energy efficiency projects, explains Saida Eggerstedt, fund manager at Schroders.

“The recovery from the global pandemic has been fuelling this expansion, as governments across the world are looking to stimulate economies and create jobs while committing to ambitious environmental targets.” 

“The rapid growth partly reflects the early stage of the green bond market in general and sovereign green bonds in particular, which still account for only 0.2 per cent of OECD government debt,” added Kris Atkinson, fund manager at Fidelity.

“Nonetheless, we expect more governments to issue green bonds as a way of financing large-scale green infrastructure projects and R&D for next generation technologies that will be crucial to achieving the net zero transition.

“This ‘greening’ of government bonds - the backbone of global fixed income markets - could help resolve some of the pricing, liquidity, and reporting challenges that investors face.”

Nachu Chockalingam, Senior Credit Portfolio Manager, at the international business of Federated Hermes, added: “The supply of green bonds has been increasing at a rapid pace which is a great opportunity for investors as it increases the depth and liquidity of the market and allows us a greater ability to assess and compare deals and structures.

“It also means we can have structural tilts, with the opportunity to fund projects that we are more in favour of. Positively, it also puts greater pressure on governments and companies that issue these bonds to disclose more detailed climate information, set validated third-party decarbonisation targets and also articulate credible pathways for their transition.”

The pitfalls

As with all investments, there are some pitfalls. Top of the list are inconsistent reporting standards across different countries. 
“Standards today are voluntary for all green bonds and often ad hoc,” Kris Atkinson told us. “Use of proceeds reported at issuance can differ from those that are reported post-issuance, creating a risk that some issuers will overpromise then fail to meet expectations. Variable reporting and a lack of common terminology and metrics can make it hard to know what the real impact has been and to compare investments. 
“Help is on the way, however. Investment standards for green bonds are being developed at a global and regional level, most prominently the EU Green Bond Standard. As these are adopted, the green sovereign market will become more investible and act as a benchmark for green corporate bonds.”
And, as M&G pointed out recently, high investor demand for green bonds, for example, has created a so-called ‘greenium’ (green premium), and the securities frequently offer a lower yield compared to similar bonds without the green label.

“Investors buying green bonds should carefully assess the use of proceeds for the bond and also if the return of it is adequate compared to a bond that is not-labelled green by the same issuer,” said Nachu Chockalingam. “There is a concept of “greenium” in the marketplace today which often means green bonds will trade at lower yields than non-green or sustainable bonds of the same issuer because of their greater demand – and we, as investors, need to make the judgement call if that is right.”

“There will always be ‘bad eggs’,” commented Ryan Lightfoot-Aminoff, senior research analyst at Chelsea Financial Services. “The oil and gas sector’s first green bond was issued by Repsol in May 2017 raising €500 million, for example. The Spanish giant claimed the finance would help it cut carbon emissions by 1.2 million tonnes within three years. However, the money was to go towards upgrading and making its existing fossil fuel refineries more efficient.

“So, questions do need to be asked. As with most investments – especially bonds that require a lot of due diligence and research - retail investors are probably better off getting access to these bonds via a fund rather than trying to pick one themselves. That way they get diversification and fewer nasty surprises.  

“The size of the green bond market looks set to explode of the next few years,” concluded Ryan Lightfoot-Aminoff. “Working out which firms will benefit and when to invest in them will be central to generating long-term value for bond investors.” 

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested. The views of Ryan and the fund managers are their own and do not constitute financial advice or a recommendation to buy or sell.

Published on 08/11/2021