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Pitfalls and promises of green bonds

Designed to finance climate-related initiatives, the issuance of green bonds has developed quickly.

But potential investors need to be aware not only of the promises, but also the pitfalls, of investing in this area, writes EFG Asset Management’s Michael Leithead.

Green bonds are defined as fixed-income securities that raise capital for use in projects or activities with specific climate or environmental sustainability purposes.

They are generally issued in accordance with a set of voluntary guidelines known as the Green Bond Principles (GBP).

Their issuance has grown strongly but this is still a market in its relative infancy.

Green bond principles

There are four core key components of the green bond principles:

The use of proceeds should be appropriately described in the legal documentation. The GBP recognise several categories of eligibility including: climate change mitigation, climate change adaptation, natural resources conservation, biodiversity conservation and pollution prevention and control.

The issuer must clearly communicate the process by which the project is evaluated, how it fits the eligible green projects categories and the related eligibility criteria.

The management of proceeds (net of expenses), which should be credited to a sub-account or sub-portfolio or otherwise tracked in an appropriate way by the issuer. The balance of the tracked net proceeds should be periodically adjusted to match allocations to eligible Green Projects made during the period.

The issuer should make and keep readily available, up-to-date information on the use of proceeds. This should be renewed annually until full allocation of the proceeds has been made and investors should be made aware of any material developments on a timely basis. These characteristics make green bonds similar to project finance and we think they should be regarded as a distinct set of fixed income instruments.

Benefits

Generally, the more detailed the documentation and reporting, the greater will be the credibility of the issuer and the greater the appeal to investors.

The issuers stand to gain a number of benefits.

They may enable issuers to diversify their investor base; to create heightened engagement with investors on green issues; improve the green credentials of the issuer; and show that the issuer is considering climate risks.

Growth and structure of the market

Figure 1 – Issuance by Country

The green bond market has grown significantly in size.

Such bonds were first issued in 2007, but a substantial boost in issuance has been seen since around 2014.

Issuance exceeded $200bn (€182bn) in 2019, while euro-denominated issuance surpassed that in US dollars for the first time in 2018.

One of the main reasons was large-scale issuance from eurozone sovereign issuers (mainly France, Belgium and Ireland).

Consequently, euro-denominated issues are now the largest segment of the main market index (see Figure 1).

After sovereigns, utilities and financial companies are the largest issuers (see Figure 2).

The market is dominated by higher-rated issuers, with threequarters of outstanding issues rated A- or higher.

For these reasons, the yield on such issues tends to be quite low.

Attitudes to investing in green bonds

There is a range of attitudes to investing in the green bond market.

Figure 2 – Issuance by Issuer

Central bankers, notably, have expressed different opinions.

Mark Carney, outgoing governor of the Bank of England, has welcomed their introduction, especially as they help focus attention on the risks of climate change.

Meanwhile, incoming ECB Governing Council member Isabel Schnabel is against the purchase of such bonds by the ECB in its asset purchase programme, being concerned about a lack of liquidity in these instruments.

We generally adopt a cautious approach to the market at the moment, but anticipate that as it develops further we will take a more active involvement.

This article was written for Expert Investor by Michael Leithead, head of fixed income at EFG Asset Management.

Part of the Bonhill Group.