Commentary by Kunal Mehta, senior investment specialist, fixed income, and Loubna Moudanib, credit analyst in Vanguard's Fixed Income Group.
Interest in environmental, social and governance (ESG) investing has grown rapidly in recent years as investors increasingly look for ways to mitigate ESG-related risk or effect meaningful change. Fixed income is no exception to this trend, as bonds marketed under a number of ESG labels have proven popular with investors.
These include social bonds, whose proceeds are used to finance or re-finance projects that provide clear social benefits; sustainability-linked bonds, which have financial or structural characteristics that can vary depending on whether the issuer achieves predefined sustainability or ESG objectives; as well as green bonds, which back projects with clear environmental benefits1.
But the rise of these bonds has been accompanied by some confusion around both how to define them and how to analyse their green credentials. The rapidly expanding universe of green bonds in particular has stimulated a great deal of debate and misunderstanding among some investors.
Corporate green bonds now make up around 1.8% of the Bloomberg Barclays Global Aggregate Corporate Bond Index, up from less than 0.4% five years ago2, driven by rising issuance, growing institutional demand and increasing standardisation.
As with any other kind of financial instrument, it’s important for investors in green bonds to understand the risk and performance implications of what they’re investing in.
The green-bond opportunity set is growing swiftly – research from Morgan Stanley suggests that European green bond issuance during the first quarter of 2021 equates to half of the total issued during the whole of 20203. Governments, for one, are ramping up their issuance of green bonds. In 2020, EU leaders agreed to borrow €750 billion to provide grants and loans to help member states to recover from the Covid-19 pandemic, part of which will take the form of green bonds. Similarly, the UK’s Debt Management Office has announced a green-bond issuance programme in response to the pandemic as well as to boost its sustainable finance program, with plans to issue two “green gilts” in 2021.
Corporate borrowers are following sovereign issuers’ lead, increasing their green bond issuance and taking advantage of the typically lower funding costs of green bonds relative to non-green bonds while boosting their green credentials, allowing them to tap into the growing investor appetite for green bonds.
In 2014, Bloomberg Barclays and MSCI introduced a benchmark to represent the green-bond universe, the Bloomberg Barclays MSCI Global Green Bond Index. Initially the benchmark tracked a handful of issuers, limited to development banks and supranational entities, but today it also includes a large number of corporate issuers and the debt the index tracks has risen from $15 billion at inception to around $600 billion today4.
Source: Bloomberg Barclays, as at 31 December 2020
But while the market for green bonds has grown significantly, how do the returns offered by green bonds compare with their non-green peers?
For new issues, there does appear to be an initial “greenium”—a premium over non-green bonds—as green bonds tend to trade at tighter spreads than conventional bonds. New bond issues are typically priced to include a new-issue premium—that is, an extra yield above that offered by bonds already in the market—to attract investors. As strong investor interest has driven oversubscription in new green issues, the average spread tightening from the initial pricing to issuance for green bonds has been 23 basis points for debt issued in Europe over the past four years, relative to 19 basis points for conventional bonds5. It’s important to note that spreads can vary by sector and issuer.
Average corporate spread compression from initial pricing to issuance – green versus non-green bonds (in basis points)
Source: Bloomberg Barclays, as at 31 March 2021.
However, when you look beyond the spreads at issuance, we have observed no evidence of consistent green-bond outperformance relative to “plain vanilla” bonds. On aggregate, our analysis shows that green bonds performed broadly in line with conventional bonds over the past one- and five-year horizons, on a risk-adjusted basis6.
And based on our analysis of green bonds relative to non-green bonds from the same issuer with otherwise identical characteristics, we have found no strong evidence of a consistent “greenium” which endures beyond issuance7. What’s more, based on the evidence to date, we can’t conclude that green bonds provide better (or worse, for that matter) shock-absorbing properties than conventional bonds in the event of interest-rate hikes, credit downgrades or macroeconomic shocks.
Green bonds rank “pari passu”—that is, they claim equal seniority—with an issuer’s other bonds in the same structure, and in terms of fundamental credit analysis, credit risk sits at the issuer level and is exactly the same for a green bond as for a non-green bond.
That said, not all green bonds are created equal. Just like conventional bonds, they differ by credit quality, currency, maturity and structure, among other factors, and are subject to the same fundamental analysis. Investors also need to be mindful of the practice of “greenwashing”, whereby some firms may engage in certain behaviours—such as issuing green bonds—motivated more by reputational aims than by environmental goals.
And while the green-bond market is rapidly expanding, diversification remains relatively low, particularly among corporate bonds. For example, the Bloomberg Barclays MSCI Global Green Bond Corporate Bond Index includes bonds across eight currencies and 16 sectors. By contrast, the Bloomberg Barclays Global Aggregate Corporate Bond Index comprises bonds spanning 13 currencies and 20 sectors8. The green bond index is also relatively concentrated among a small group of leading issuers, with the top-10 names making up 42%, 40% and 83% of the value of the USD, EUR and GBP sub-indices respectively9.
Bloomberg Barclays Global Aggregate Corporate Bond Index and Bloomberg Barclays MSCI Global Green Bond Corporate Bond Index by currency and sector
Source: Bloomberg, as at 28 February 2021.
Given these outsize exposures to certain currencies, sectors and issuers relative to the broader market, fundamental credit research and analysis is crucial while the green bond universe continues to grow and become more diversified.
The green bonds space has experienced rapid growth, but it is still in its infancy relative to other fixed income sub-asset classes. As the market evolves, new regulation and advances in standardisation—such as the International Capital Market Association’s Green Bond Principles and the EU taxonomy of green economic activities and Green Bond Standard—will likely bring further transparency and accountability.
We apply our rigorous analytical approach to any bond, be it green or conventional. And for investors, focusing on keeping costs to a minimum, taking a long-term approach and being diversified apply just as much to green bonds as they do to any other type of investment. With green bonds forming a growing part of major indices, understanding the unique risks involved is pivotal to managing fixed income portfolios. We anticipate that green bonds will play an important role in debt markets going forward.
1 Source: International Capital Market Association, as at 28 February 2021.
2 Source: Bloomberg Barclays, as at 28 February 2021.
3 Source: Morgan Stanley Research, April 2021.
4 Source: Bloomberg Barclays, as at 28 February 2021.
5 Source: Bloomberg Barclays, as at 31 March 2021.
6 Source: Vanguard.
7 Source: Vanguard.
8 Source: Bloomberg Barclays, as at 28 February 2021.
9 Source: Bloomberg Barclays and Vanguard, as at 31 December 2020.
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