How Green Bonds Protect Investors Against Climate Fears
Image: Climate Bonds Initiative
The United Nations sixth assessment report was released this week confirming what many had already suspected: The Earth is on track to get (at least) 1.5 degrees hotter in the next 20 years, and humans are to blame for it. This means we can start readying ourselves for more fires, flooding, droughts, food shortages, and animal extinctions. Investors have taken notice, according to Jessica Matthews of Forbes, and are increasingly turning to green bonds.
As of now, there are 128 global asset managers representing $43 trillion in assets that have committed to helping hit the goal of net zero greenhouse gas emissions by at least 2050. Investors had contributed some $2.24 trillion in sustainable mutual funds and ETFs by the end of June, a 12% increase from the prior quarter.
How Do Bonds Work?
A bond is effectively a loan made by an investor to corporation, municipality or government agency to fund operations or a project. Bonds have specific end dates, called “maturity dates,” where the issuer must return money to the investor. The company or agency pays an investor interest throughout the duration of the bond.
Green Bonds
Green bonds are debt that is … well … green. They’re structured the same as traditional fixed income securities, but earmarked for projects explicitly contributing to reducing the carbon footprint (think water projects, energy-efficient buildings or electric vehicles). Green bonds have the same structure as their non-green counterparts, so they theoretically carry the same credit structure. Green bonds are having a moment in the spotlight.
The market surpassed $1 trillion in assets last year, with $290 billion in green bonds issued in 2020, according to Morningstar. In 2021, issuance is projected to hit $500 billion. To be sure, it’s only about 1% of the global bond market and expanding quickly.
Development of Green Bonds
The first green bond was issued by the European Investment Bank in 2007, focused on renewable energy efficiency. In 2013, EDF, Bank of America Merrill Lynch and Vasakronan issued green bonds tripling the size of the green bond market ($11 billion in assets) by the end of that year. Verizon raised nearly $1 billion in an issuance in 2019 for things like renewable energy projects and upgrading its facilities to energy-efficient lighting across its facilities; and Apple funded 17 green bond projects in 2020, some of which are part of its effort to go carbon neutral by 2030.
During the pandemic, local governments have been using municipal bonds to fund increasingly green capital projects. S&P Global Ratings identified 176 unique issuers of green muni bonds from 2020 in a report earlier this year, and 109 of those were first-time issuers. It predicts that the U.S. municipal green-labeled debt sector will make up about 4.1% of all municipal issuance by the end of this year.
Investing In Green Bonds
Right now, the primary bond market—green or not—is heavily saturated with institutional investors like pension funds, insurance companies or hedge funds. The secondary market (where investors are purchasing bonds from other investors, rather than the issuers themselves) is still niche but growing.
As of May 2021, there were 76 green bond funds globally with around $25 billion in assets, according to Morningstar, with 65 of them being housed in Europe. The iShares Green Bond Index Fund (IE), which is domiciled in Ireland, is the largest green bond fund with some $3.4 billion in assets.
Differences from Traditional Bonds
Green bond funds do tend to be more expensive: The two U.S.-domiciled green bond ETFs cost 0.25% per year. That’s compared with 0.08% or 0.09% for a more general bond ETF, according to Morningstar. ESG investments, in general, sometimes don’t benefit from the same economies of scale as their counterparts, and they can have extra costs for things like shareholder advocacy.
The theoretical premium an investor pays for a green bond over a traditional one, given high demand is known as “Greenium”. There is academic debate on how to detect it or whether there even is one at all.
Other key differentiators: Green bonds have a higher average duration, but a lower average yield to maturity than standard bonds. Green debt funds tend to have more exposure to BBB rated bonds (which typically corresponds to a search for a higher yield)—meaning they have higher exposure to credit and duration risk.
Weighting and Performance
The green bond market is weighted differently, as most of this debt is being issued in Europe and—in the U.S.—specifically by corporations. If an investor were to swap out the iShares Global Aggregate Bond ETF for its green bond ETF, exposure to the euro would increase to 68% from 23.6%, and exposure to U.S. bonds would lower to 20.7% from 42%, according to Morningstar.
Due to green bond funds being weighted differently, they will perform differently, too. The iShares Global Green Bond ETF, for example, had a 1-year total return of 1.12% at the end of July. A more-traditional bond counterpart, the iShares Core Global Aggregate Bond UCITS ETF, had a lower 1-year total return , at 0.63%.
The NuShares ESG U.S. Aggregate Bond ETF (NUBD), which launched in 2018 and has a 3-year total return of 5.34%. It was down -0.88% from the end of July from January. The VanEck Vectors Green Bond ETF (GRNB) had a 3-year total return of 3.82% at the end of July, but was down -0.45% from January.
One of the most popular traditional bond ETFs, the Vanguard Total Bond Market ETF (BND), performed better than both these funds over the last three years, with a total return of 5.83% at the end of July. It was down -0.63% at the end of July from January.
