Coming soon: The $1 trillion ‘green’ bond market

The environmentally-friendly asset class is becoming increasingly popular. However, investors must not be seduced by the green label and use caution.

Summary: The “green bonds” industry is poised to get a lot larger very soon, with estimates putting new issurance at $1 trillion in bonds in five years. As it continues to grow it’s clear that the woes of climate change have attracted investor attention, with a growing consortium of big-name pension funds, governments and asset managers aiming to build out the industry.

Key take-out:  The lessons here are relevant to the entire and burgeoning asset class: With the explosion of product offerings coming to market, investors must not be seduced by the green label, but must conduct suitable due diligence and analysis to make sure they are sinking money into sound investments.

Key beneficiaries: General investors. Category: Fixed income.

Looking to profit from environmentally-friendly assets? The Bank of America Merrill Lynch Green Bond Index tracks the now $59 billion in “green bonds” issued globally, through March of this year, and is worth a look. BofA reports that the index’s collection of climate-sensitive bonds—funding renewable energy projects for wind turbine manufacturers and solar panel makers—has returned 6.4 per cent annually, beating other global bond indices since its debut a little over four years ago.

While it’s too soon to get overly excited about those returns—in 2011 and 2012 there were fewer than a dozen such bonds to invest in—the industry is poised to get a lot larger very soon, with estimates putting new issuance at $1 trillion in bonds in five years. The BofA index only tracks investment-grade green bonds so it also serves as a nice clearinghouse for sourcing environmentally-friendly investments.

As the green bond industry continues to grow, it’s clear that the woes of climate change have attracted the attention of investors. European governments, such as France, Germany, and Netherlands, have continued to lead the pack with 36 per cent of the market’s issuance. The World Bank has issued $8 billion in green bonds, too. But, in 2014, there was a noticeable spike in corporate and U.S. municipality bonds snapped up by investors, which partially contributed to last year’s $36 billion in new issuance, up from $11 billion in 2013. Bonds have surfaced from companies like SolarCity and Toyota Motors, alongside state-sponsored clean development projects out of Connecticut and California.

The BofA index is international in its scope, made up of 300 different issues, from 19 countries, and in 23 currencies. That proliferation led industry tracker Climate Bonds Initiative to predict that the overall green bond market would swell to $100 billion this year and then balloon to $1 trillion by 2020.

That estimate might seem rosy were it not for the growing consortium of big-name pension funds, governments and asset managers aiming to build out the industry. The Investor Network on Climate Risk has recommended a set of minimum standards for green bonds issued by banks, defining the broad categories that are eligible and suggesting that any environmental benefits be quantifiable and independently verified. PIMCO, CalPERS, BlackRock and the United Nations Joint Staff Pension Fund are among the 27 signatories who have helped define the standards.

A few words of caution. The largest green bond so far came from solar-panel installer Terraform (ticker: TERP), a “Yieldco,” which offers sizeable dividends that hinge on future government subsidized solar projects. The $800 million 8-year bond yields 5.875 per cent. Barron’s has written sceptically on the prospects of Yieldco stocks. Should projects fall through or underperform, Barron’s colleague Tiernan Ray writes, dividends could take a hit. While bonds are inherently more insulated from such threats, as Ray notes, “one should be mindful that renewables are still evolving.” Barron's has also questioned the sustainability of SolarCity’s (SCTY) business model.

The lessons here are relevant to the entire and burgeoning asset class: With the explosion of product offerings coming to market, investors must not be seduced by the green label, but must conduct suitable due diligence and analysis to make sure they are sinking money into sound investments.

Case in point: Bonds issued by the European Investment Bank—backed by the European Union—and World Bank are generally viewed as more stable. But here, too, you need to watch out. The European Investment Bank issued a 5-year green bond with a 1.375 per cent yield recently, effectively a negative interest rate of 0.026 per cent after accounting for inflation. You are in effect paying for the privilege of being green – not earning any return on investment. By contrast, the speculative-grade green bond industry continues to grow, with higher yields but more dubious financial prospects.

If you’re looking to replicate the BofA green bond index and hedge your bets across a number of different green bonds, there are not a lot of options just yet. The Calvert Green Bond fund (CGAFX), launched in October 2013, is the only pure play. It underperformed in 2014, but is beating the Barclay’s US Aggregate Bond index year-to-date. The $149 million Green Century Balanced fund  (GCBLX) is an environmentally-conscious mutual fund investing in stocks and fixed-income and “seek[s] to invest in green bonds,” though the fund’s prospectus doesn’t clarify exactly what that means.

Yet another sign the asset management industry intends to cash in on the large appetite for environmentally and socially-sensitive investments, which makes it doubly important not to accept every deal crossing your table, but to step up with cool-headed scrutiny of each green bond on offer.

Related Articles