You might have heard of Green Bonds in relation to Sustainable Investing. But how do they work and what are the risks for the average investor?
What is Sustainable Investing?
Traditional investing delivers value to investors by putting money into investment opportunities. All these opportunities carry risks that are reflected in the expected returns profile. Sustainable investing builds on traditional investing by integrating environmental, social, and governance related (ESG) insights. Sustainability means fulfilling the needs of current generations without compromising the needs of future generations, while ensuring a balance between economic growth, environmental care, and social well-being. There is a growing recognition that ESG factors are economically important, especially in the long term.
How can it be applied to stocks and bonds?
A crucial cornerstone of ESG integration is the engagement between investors and who they are investing in. This process naturally lends itself more to equity/share investing relative to fixed income investments, especially sovereign bonds. Shareholders play a role in proxy voting and shareholder engagement. Retail bondholders may not engage directly with sovereigns but one area that is increasingly interesting is that of Green or labelled sovereign bonds.
So, what are green bonds?
The money raised through a green bond is specifically allocated to projects that positively affect the environment or contribute to the fight against climate change. Green bonds can be issued by sovereigns, sub-sovereigns, supranational entities, corporates and commercial banks. Green bonds can also be referred to as labelled bonds, which is a broad term which collectively describes green, social or sustainability-linked bonds.
And how do they differ from social and sustainability-linked bonds?
Like green bonds, social bonds have strict criteria surrounding their use of proceeds: they must be finance or refinance projects that achieve positive social outcomes and/or address a social issue.
Meanwhile, sustainability-linked bonds differ slightly from green and social bonds, as their proceeds are not used to finance particular projects but rather finance the general functioning of an issuer with explicit sustainability targets. The targets are linked to the conditions of the bond.
What are the risks?
The credit profile and risks of green bonds are, in general, the same as for standard bonds from the same issuer. A significant consideration for investors looking to invest in green bonds will be the duration aspect. Bond prices are inversely related to interest rates, meaning that a rise in yields will lead to a fall in bond pricing. Duration measures a bonds sensitivity to interest rate moves and is significantly linked to the maturity of the bond. As such, short maturity (low duration) bonds are less sensitive to interest rate moves relative to long maturity (long duration) bonds. Linking this back to green bonds, this has important implications. Typically, a green project will have a long-term timeline and hence the bond issued to finance this project will also have a long-term maturity. As a result, the green bond market typically has a longer duration profile than the overall non-labelled bond market, meaning that investors looking to invest entirely in green bonds may have to accept additional duration risk. Of course, there are some shorter maturity green bonds available and as time passes and the market grows the opportunities will increase further.
What does it mean for investors?
Green bonds are growing in popularity as they offer investors the opportunity to gain exposure to bonds and contribute to the fight against climate change. At the end of 2022, the green bond market surpassed the $2trillion level. In first half of this year, the sale of green bond issuances hit a new record, surpassing the previous record set in H2 2021. Among these issuances was a record green bond sale in April, a €10bn green bond issued by Italy.
Adding an allocation to green bonds within a diversified portfolio offers investors the ability to tilt their investments towards contributing to the fight against climate change.