By Monika Netelenbos, fixed income product specialist at J. Safra Sarasin Sustainable Asset Management
Over the past few years, investors have become more aware of climate change and the need for immediate action. For investors looking to invest sustainably, green bonds are a compelling investment solution, offering similar returns to traditional bonds. Improved regulatory frameworks and increased disclosure have further supported this segment, making it more transparent and attractive.
Labelled, sustainable, green – the basic terminology ‘green bonds’ are part of the labelled bond family, an overarching term to describe fixed income instruments with an explicit non-financial outcome intention: green, social, sustainable and sustainability-linked.
The first three categories are based on the principle of ‘use of proceeds’, in which the issuer aims to finance projects with positive environmental and social impact. Projects that belong to the green category are primarily renewable energy plants. Apart from energy production, labelled bonds cover several more categories, including infrastructure projects, energy-efficient real estate, projects that protect and conserve coastal areas or create new forest hectares, and R&D-related projects.
The sustainability-linked category is more recent and targets a corporate-level sustainability purpose, which is linked to defined objectives and penalties in case that the targets are not achieved (e.g., carbon emission reduction). Each bond category adheres to its own set of principles established by the International Capital Market Association.
Labelled bond market positioned for further expansion
Investor preference for Sustainable Development Goals (SDG) contribution is shifting the focus to investment solutions that seek to support the vision of the Global Goals adopted by the United Nations in 2015. Labelled bonds, with their clear social and environmental focus, are well-positioned to attract investors seeking SDG contribution.
Green bonds: From birth to growth
The European Investment Bank issued the first green bond in 2007, launching the green bond market. The adoption of the Paris Agreement in 2015 further propelled the market’s expansion. In addition, the establishment of the Green Bond Principles played a pivotal role in promoting enhanced transparency and increasing credibility of this asset class.
More recently, the market has delivered double-digit growth, with record issuance in 2021, highlighting its increasing significance. The momentum slowed down in 2022 due to turbulences in the fixed income sector. In 2023, the labelled bond segment continued its robust progression with an annual issuance volume of 321bn USD through July.
From developed to global markets
While the main market for green bonds is Europe, they are also gaining traction in other developed and emerging markets. This is a positive trend since emerging economies play a central role in combating global warming and environmental problems of global proportions.
It is therefore very encouraging that China, India, Brazil, and Mexico are joining this segment. In 2022, 23% of green bonds were issued in emerging markets. China has surpassed the US as the main source of green bonds, accounting for 18% of total green bond issuance volume (Climate Bonds Initiative 2022).
Additionally, international organizations, development banks, and financial institutions are actively supporting the development of green bonds within emerging markets.
Green bonds in fixed income portfolios and the ‘greenium’
Green bonds can also add value from a portfolio management perspective. Primarily, realized returns on green bonds have been higher than theory would suggest. This difference between expected and realized returns can be attributed to the ‘greenium’, that is, investors preferences for green assets during the lifespan of the bond. Additionally, the premium that investors are willing to pay for green assets, fluctuates over time. It tends to increase during risk-off periods and decline during risk-on phases, thereby reducing the overall risk profile of the portfolio.
Diversification is another important consideration for investors. While in the early days of the green bond market, the universe was very limited, we now see a broader choice across sectors, countries, currencies and maturities and expect it to further diversify.
In terms of credit quality, most of the issuers have an investment grade rating, underlining the overall high quality of the segment. Moreover, transparency is assured as the issued bonds are accompanied by detailed information as to the utilization of capital, enhancing investors’ understanding of both the bond issuance objective and the issuers’ profile. Consequently, there is a sound investment case for green bonds: the investor does not need to compromise on returns and credit quality, while gaining exposure to positive environmental and societal impacts.
Positive outlook for bonds that finance green transition
Due to the need to anticipate and address climate change and finance projects related to the energy transition, green bonds are likely to see increased demand in the coming years. Accordingly, governments and regulators worldwide are introducing policies and frameworks that incentivize and facilitate green bond issuance, creating a favourable environment for further growth, ensuring better transparency and improving the integrity of the universe.
Finally, the labelled bond market continues to evolve, with new structures, products, and standards emerging also for the social area. Its innovative nature, coupled with increased investor awareness and education, will contribute to the continued growth of the labelled bond market in the coming years.