What Are Green Bonds?

The trend in favor of sustainable investments is well-entrenched, and while many investors are happy to approach this growing market in a generic way--that is, favoring companies with good environmental, social and governance, or ESG, credentials--others go a step further and seek investments with an explicit and measurable impact.

Green bonds belong to this category. They’re a fairly new breed of bonds, and, though still a niche market, they are seeing significant growth.

Still, many investors still don't know what exactly green bonds are, let alone the role they can play in their portfolios. How do they differ from a non-ESG option? In our white paper, we aim to provide answers to these questions.

What Are Green Bonds?

Green bonds are issued by governments, supranational organizations, and companies to finance environmental and climate projects exclusively. These projects are commonly focused on:

• renewable energy,
• green buildings,
• sustainable water, and
• clean transportation.

This sets them apart from standard bonds, where the issuer has the freedom to use the money raised for a variety of purposes, which may or may not be centered on ESG issues.

In addition to the exclusive use of proceeds, issuers of green bonds are required to provide:

• a detailed outline of the project they wish to finance,
• information on the project's progress (typically annually), and
• its expected impact.

Who Issues Green Bonds?

The first green bond was issued in 2007 by the European Investment Bank. Green bonds were a tiny slice of the bond market for the next decade, with issuance mainly coming from government agencies and development banks. But since 2016, the market has seen a significant increase in issuance every year and from a wider variety of issuers, including sovereigns and corporations.

Today, the bulk of green bond issuance comes from Europe, and governments and the European Union are becoming key players in this market. This is partly driven by regulatory and policy drivers such as:

• The Paris Agreement,
• The European Green Deal, a set of policy initiatives by the European Commission to make Europe climate-neutral in 2050, and
• The EU's EUR 750 billion Recovery Fund to fight the effects of the coronavirus pandemic, which plans to raise around 30% of the capital with green bonds.

In the United States, green bond issuance is largely driven by corporations and, to a lesser extent, local authorities. There is also a budding market of securitized green bonds issued by the likes of Fannie Mae, Freddie Mac, and Ginnie Mae.

However, there are no concrete plans for the federal government to enter this market, although some market commentators have raised expectations that the Biden administration’s focus on sustainable infrastructure investment could pave the way for the launch of green Treasuries.

Elsewhere, green bond issuance in emerging markets is minimal. China dominates this minor universe; however, Chinese local green bond standards are fragmented and not entirely aligned with international green bond definitions. This means that some green bond investment funds purposely avoid them.

How Big is the Green Bond Market?

According to the Climate Bond Initiative, green bond issuance hit a record high of $290 billion in 2020 (a 246% increase from 2016) and is on track to hit $500 billion in 2021. This propelled the size of the green bond market to more than $1.2 trillion.

While growing, green bonds are still a niche segment of the global bond market, barely accounting for 1% of its estimated size.

Morningstar has identified 76 funds--67 active and nine passive--currently available for sale whose declared investment objective is to provide exposure to the green bond market. Of these funds:

• 65 are domiciled in Europe,
• seven are domiciled in the United States,
• two are domiciled in Asia,
• one is domiciled in Canada, and
• one is domiciled in Australia.

Assets in green bond funds amounted to $25 billion at the end of the first quarter of 2021. The vast majority (82%) of assets resides in active funds, with 18% in passive funds. At this stage, the increase in assets is largely driven by net new flows.

Total flows in 2020 amounted to $10 billion, up from $4.7 billion in 2019. Flows in the first quarter of 2021 amounted to $2.7 billion, which suggests another good year for these funds.

What Role Can Green Bond Funds Play in My Portfolio?

While the green bond market has certainly grown past its infancy, investors shouldn’t yet consider it a substitute for traditional bond exposure. Investors in a global green bond portfolio would typically take on more credit and duration risk compared with a traditional global aggregate bond portfolio.

A few considerations of green bonds as compared with the traditional global bond universe:

• The green bond cohort is heavily skewed toward euro-denominated bonds at the expense of U.S.-dollar-denominated bonds.
• It's more heavily skewed toward corporate, agency, and supranational bonds, while government bonds are significantly less represented. (However, their weight is expected to grow in coming years.)
• Green bonds bring additional credit risk in aggregate, with more exposure to BBB rated bonds compared with a plain-vanilla global bond offering.

Asset managers we spoke to concur that the specificities of green bonds and the current structure of the market mean that allocation to green bond funds is driven by investors’ desire to add an impact sleeve to their portfolios rather than a substitute for traditional fixed-income holdings.

The latter can be more easily achieved via the fast-growing number of broad ESG-screened bond funds. These funds focus on the issuer’s ESG credentials rather than on whether the bonds are used to finance green projects and typically have similar risk/reward characteristics as non-ESG alternatives.