Green Bonds: a new perspective in the Fixed Income market

Paolo Bascelli, Milan, 11/02/2019

1. Introduction

The theme of sustainability represents a major priority globally and this trend is evident if we
consider the increasing popularity, in the financial world, of sustainable investment methods that
are based on the respect and the application of the ESG criteria (Environmental, Social and
Governance). The main focus of the sustainable investing is on equity. However, recently, a new
dimension regarding bonds is opening in the ESG universe: they are gaining more relevance in
terms of issuances (fig.1) and in terms of new academic papers investigating about the difference
in risk between investing in a traditional bond and investing in a green bond.


Figure 1. Green bonds issuances from 2013 to 2018.

The first institutions that issued green bonds are the World Bank and the European Investment Bank
(BEI), followed by the International Finance Corporation (IFC), an agency which reports to the
International Bank for Reconstruction and Development (IBRD). However the market of
sustainable bonds is attracting a lot of new types of issuers, which go from local governments to
private firms, as shown by the new green convertible bond issued by Tesla Motors and the green
bonds issued by Italian firms as Hera and Enel. The countries leading in the issuance of green bpnds
are United States and China, followed by France which surpasses the supranational institutions
issuing green bonds, not in the number of green bonds issued, but in the total monetary value of
issuances (fig.2).


Figure 2. Top countries or supranational issuers of green bonds until 2018.

Despite of the data formerly shown, from which seems evident the growth of the green bonds
market, it must be said that actually the market of sustainable or green bonds, stands for only a
0,5% of the global bond market. Moreover, these titles are negotiated only on the primary market,
due to the lack of offer compared to the demand of these bonds: inevitable consequences are a
larger bid/ask spread and a scarce liquidity of green bonds.


2. What is a green bond?

Green bonds are debt instruments, where the proceeds are used to finance the realization of
sustainable projects (renewable energy development, realization of new eco-sustainable ways of
transport, enhancement of waste management and realization of commercial and residential
buildings energy efficient, only to make a couple of examples). Green bonds are issued by public
and private institutions. The issuance of a green bond involves three different subjects: the
underwriter of the bond, the issuer and an independent rewiever as an audit firm or a rating agency,
such as Moody’s (fig.3).


Figure 3. The subjects involved in the process of issuing a new green bond (fonte: Josuè Banga, “The green bond market: a potential
source of climate finance for developing countries, Journal of Sustainable Finance & Investment, 2018)

The preminent role is carried out by the independent rewiever: it has to analyze the green project to
finance, quantitatively and qualitatively, before the issuance of the green bond; it must ensure that
the project to finance respects the Green Bond Principles (an operative framework realised by the
International Capital Markets Association); it must monitoring how the proceeds of the bond are
used; it must perform an analysis and a monitoring of the credit rating of the green bond issuer;
finally it must ensure that the issuer is transparent toward the underwriters of the bond, giving them
periodic informations about the realisation of the sustainable project and explaining to underwriters
how the proceeds of the bond are being used.


There are four types of green bonds: Standard Green Use of Proceeds Bond; Green Revenue Bond;
Green Project Bond; Green Securitised Bond. The first type of green bond is a standard recourse-to-the-issuer debt obligation. The second type of green bond is a non-recourse-to-the-issuer debt
obligation in which the credit exposure in the bond is to the pledged cash flows of the revenue
streams, fees and taxes. The Green Revenue Bond is used mainly by public entities. The third type
of green bond is abond issued to finance one or more projects: the underwriter has a direct exposure
to the risk of the project and has an additional possibility, not an obbligation, to recourse to the
issuer. The latest type of green bond is a bond collateralised by one or more specific green projects,
following the typical pattern of a securitization.


3. The importance of green bonds in sustainable investing

The transition to a global economy more sustainable and more efficient energetically and
enivironmentally requires plenty of financial resources to be achieved. Green bonds are useful, in
this way, for many reasons. Firstly, green bonds amplify the opportunities of capital allocation for
investors, giving them a new instrument for a mid-long term investment in sustainable projects. At
the moment, empirical evidence, cannot prove irrefutably that green bonds perform differently or
better than traditional bonds: what can be surely stated is that the respect of specific principles of
sustainability and transparency are significantly linked to a credit risk reduction without, at the
same time, sacrificing returns (fig.4).


Figure 4. Initial findings on the correlations between ESG criteria and sustainable bond performances (fonte: Inderst, Stewart,
“Incorporating Environmental, Social and Governance (ESG) factors into Fixed Income Investments”, World Bank, aprile 2018)

Secondly, green bonds lighten the burden of green financing from the banking sector, which is the
primary channel used by public and private entities to collect financial resources to finance
sustainable projects. This helps in terms of risk management and in terms of asset-liability
management. Thirdly, the duties originating from the issuance of a green bond and the commitment
of the issuer to give periodic information to the underwriters of the bonds, give the opportunity to
the issuer to improve their credibility and, at the same time, encourage other subjects to create new
sustainable businesses. Furthermore, financial instruments like green bonds expand the group of
investors interested in green financing, reaching entities like insurance companies, pension funds
and sovereign wealth funds that constantly search new financial instruments with a long-term
maturity and a mid-low level of risk. Finally, is considerably reasonable that green bonds, in the
future, can have benefits in terms of funding costs compared to traditional bonds: in some countries,
like the United States, there are discussions about a series of tax incentives (in particular tax
reduction and interest subsidies), rewarding subjects that participate in this form of investment.


4. Conclusions

The green bond market is still relatively small if compared to the traditional bond market, although
is growing rapidly. Hence, the weaknesses of a non-mature financial market are still present, such
as liquidity risk, the impossibility to have historic series of yields that can help analyzing the
performance of single green bonds, large bid/ask spreads, a huge demand of green bonds if
compared to issuances, with the consequence of higher prices and lower returns. However, more or
less, all public and private institutions are trying to concentrate their efforts to promote this green
way of investing, which is complementary to the existing equity instruments based on the ESG
criteria. It has to be considered in this way the creation of the first ETFs based on green bonds, such
as Lyxor’s and Blackrock’s, and the realisation of some indexes, like the S&P Green Bond Index,
which aims to track the trend of the global green bond market. So, it is worth considering the
allocation of a small fraction of own assets on green bonds, with the perspective of incrementing
this fraction, in accordance to the increasing depth and liquidity of the green bond market, in order
to seize the opportunities, growing and improving, in terms of risk/return, of the near future.


Moreover, we invite you to follow a series of operative precautions to invest in a green bond:

1) Reason on a long term horizon (5-10 years at least);

2) Prefer a buy and hold strategy;

3) Pay attention to the type and to the seniority of the green bond;

4) Pay attention to risk credit, do not consider only the rating assigned to the issuer by audit firms
and rating agencies.


Disclaimer: This article represents the opinions of the author and of the supervisor. No compensation is received for the expressions of these opinions. Here we declare, in addition, to have no commercial relationship with societies and research institutes cited in this article.

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