Should You Pay More for Green Bonds?
‘Greenium’ is shorthand for ‘green premium’. When applied to fixed income investments, like bonds, the ‘greenium’ describes the difference between the yield of a ‘green bond’ – the ‘yield’ being a measure of the income returned, or earned, on the investment – and the yield of a conventional, non-green bond from a similar issuer.
What this amounts to is lower borrowing costs for issuers of green bonds, and higher costs for their investors. It is, essentially, the way that ‘price’ is assessed in the green bond market.
Many investors want to have a positive impact on environmental factors, particularly on climate action11, and, in the search for integrity, a number of funds have been converting to green labels. Stocks have traditionally led this revolution, but there has been an increase in demand for green bonds of late too2.
Some have observed that the increase in dedicated green bond mandates means a growing number of investors have become forced buyers of a concentrated number of deals, pushing the prices up regardless of the financial characteristics of the offering.
Yet others argue that a greenium is justified in some cases because the green label can be a proxy for good management, increased disclosure, and a clear, long-term business strategy at an issuer – essentially, the G the ESG (environmental, social and governance). And if these are things that an investor ultimately wants from their green investment, then paying the premium makes a lot of sense.
Either way, the gap has been narrowing between what investors are willing to pay for green bonds versus more traditional bonds. In Europe, which boasts the most developed green bond market, the greenium has shrunk from over 9 basis points (bps) in 2020 to between 1 and 2 bps in 20223.
Research has found that the risk-averse environment that has caused a wider yield differential – the ‘credit spread’, or difference between the return of two different debt instruments with the same maturity but different credit ratings – should benefit green bonds, which are often more robust than conventional bonds under such conditions5.
It equates this positive assessment to the more defensive profile displayed by the green bond universe, their popular ‘impact’ characteristics – financing projects that contribute positively to the environmental and energy transition, such as the development and storage of renewable energy – and also their investor base, which is believed to have a longer investment horizon.
Scaled according to the issuing sector, the research says the greenium tends to be lower in sectors where conventional bonds are expected to be in a minority and replaced by green bonds5. These sectors include utilities and financials.
The utilities sector operates at the heart of the energy and environmental transition and, structurally, issues a large number of green bonds. Financials, on the other hand, have large financing needs, including the funding of many green assets – often real estate.
Cyclical sectors displayed a higher greenium, however – the consumer goods sector, for instance, is still at a very early stage in the green bond market. Car manufacturers and their suppliers, meanwhile, are issuing on a recurring basis to finance the production of cleaner vehicles.
But it’s in sustainability linked bonds (SLBs) where the largest growth in issuance volumes have been seen in recent years55 – and where there’s the most potential for competition with green bonds.
The issuer of an SLB can therefore use the proceeds for general purposes and is not required to track the projects funded by the issuance. This flexibility afforded to the issuer – in that they have the freedom to choose how they intend to achieve their sustainability targets – makes SLBs highly attractive. After all, any company can issue an SLB, whereas the same cannot be said of a green bond.
Sectors that issue large amounts of SLBs relative to green bonds will widen the greenium. Examples include industrials – with the exception of the car industry – and consumer goods, as well as the pharmaceutical and technology sectors. In contrast, current regulations stipulate that the financial sector – and banks in particular – cannot issue SLBs.
In short, the emergence of SLBs could slow down the growth of the green bond market, preventing the greenium from shrinking in some sectors.
Moreover, the renewed focus on ‘greenwashing’ – SFDR came into force in Europe last year, while the SEC has proposed similar rules in the US – and closer regulatory scrutiny, may result in a more robust greenium for select issuers.
Green conviction for your fixed income allocation.
- Fixed income – an asset class that pays out a set level of cash flows to investors, typically in the form of fixed interest or dividends, until the investment’s maturity date – the agreed-upon date on which the investment ends, often triggering the bond’s repayment or renewal. At maturity, investors are repaid the principal amount they had invested in addition to the interest they have received. Typical fixed income investments include government bonds, corporate bonds and, increasingly in recent years, green bonds.
- Impact investing – relates to strategies that may invest in companies/organizations with explicit intention to generate positive social or environmental impact as the primary objective, alongside financial return as the secondary objective.
- Issuance – the ‘bond market’ broadly describes a marketplace where investors buy debt securities that are brought to the market, or ‘issued’, by either governmental entities or corporations. National governments typically ‘issue’ bonds to raise capital to pay down debts or fund infrastructural improvements. Companies ‘issue’ bonds to raise the capital needed to maintain operations, grow their product lines, or open new locations.
- Net zero – A concept that attempts to describe the balancing of greenhouse-gas (GHG) emissions so that the sum of all GHGs emitted from human activities is zero. The point where we get to ‘net zero’ is the point at which any residual emissions of GHGs are balanced by technologies that remove them from the atmosphere.
- SFDR (Sustainable Finance Disclosure Regulation) – Since March 2021, asset managers have been required to sort their funds into different sustainability categories based on the product's characteristics. Funds are categorized as articles 6, 8 or 9, with 'Article 9' funds requiring 'sustainable investment' as their explicit objective.The SFDR is designed to improve and standardise investment firms’ ESG reporting and allow investors to assess and compare the ESG approaches of different investment funds: essentially, to provide greater transparency for investors and avoid ‘greenwashing’ – the process of conveying a false impression or providing misleading information about how a company’s products are environmentally friendly.
- Yield – a measure of the income return earned on an investment. In the case of a share, the yield is the annual dividend payment expressed as a percentage of the market price of the share. For bonds, the yield is the annual interest as a percentage of the current market price.
2 Source : Climate Bonds Initiative, 2022, https://www.climatebonds.net/resources/press-releases/2022/08/h1-market-report-green-and-other-labelled-bond-volumes-reach-4178bn
3 Source : https://www.afme.eu/Publications/Data-Research/Details/ESG-Finance-Report-Q1-2022---European-Sustainable-Finance
4 Source : https://home.cib.natixis.com/articles/green-and-sustainable-bond-market-update-2q-2022
5 Source: Mirova, 2021