Going Sustainable with Green Bonds

    by Philippe Kybourg, ETF & Index Fund Investment Analytics, UBS AM

    The first green bond was issued back in 2007 by the European Investment Bank, with the World Bank following suit a year later. It took a number of years for this market to establish itself, but it is now a staple segment of the fixed income asset class. 

    In this article, we outline how these securities are structured and how the market has evolved in recent years. We also discuss the importance of the underlying issuer behind green bonds and how it matters in the context of building a global green bond solution.

    What are green bonds?

    Green bonds are any type of bond instruments of which the proceeds are used to enable climate-related or environmental projects. While the issuer can use regular bonds’ proceeds for any objective they like, proceeds from green bonds can only be used for sustainable objectives. Although green bonds are not bound by any regulation, their underpinning rules are described in the Green Bond Principles (GBP) outlined by the International Capital Market Association (ICMA). These principles are articulated along four dimensions:

    1. Use of Proceeds
    2. Process for Project Evaluation and Selection
    3. Management of Proceeds
    4. Reporting

    Green bonds are the best-known securities among the sustainable bonds’ universe. However, there are also other types of bonds that follow a similar “use of proceeds” structure such as sustainability bonds, social bonds, and transition bonds. Sustainability-linked bonds outline instead a certain key performance indicator related to green or social goals and apply a penalty if the target is not reached.

    Florian Cisana, Head of UBS ETF & Index Fund Sales Nordics

    How big is the market?

    The annually issued amount of green bonds has been steadily rising since 2014 and it has surpassed the half trillion USD mark for the first time in 2021 with 582 USD bn issued, while it dropped to 487 USD bn in 2022 due to challenging market conditions not specific to that fixed income segment.  From a regional lens, we see that Europe, Asia-Pacific and North America play leading roles in terms of amount issued.

    Supply of green bonds was initially dominated by development banks and non-financial corporates, while corporates, sovereigns and government- backed entities played a more prominent role in the recent years. Corporates accounted for 54% of amount issued in 2022, whereas sovereigns and government-backed entities represented around 37%.

    What are the proceeds used for?

    As mentioned earlier, one of the requirements of Green bonds are linked to the type of projects that should be financed by the bonds’ proceeds. 

    Thanks to another key pillar of the Green bonds principles, reporting, we can analyse which type of projects are financed by Green bonds. If we focus on the proceeds raised in 2022, we can see in Figure 2 that most of the proceeds are used for Energy projects, with buildings and transportation following suit. Collectively, they still contribute 77% of the total green debt volume, but in recent years smaller categories are gaining share.

    Does the issuer matter?

    The short answer is yes. Despite its green label, green bonds will mostly share the characteristics of “non-green” traditional bonds. If we take a green bond and a conventional bond from the same issuer, the credit and default risks of both securities will be the same. Their yield should, at least in theory, be similar as well. However, in practice it seems that investors are willing to pay a premium to invest in a bond with a sustainable impact. This “greenium”, which can be measured as the difference in yield between green bonds and ordinary bonds of the same maturity, has been studied extensively with varying results. The “Green Bond Pricing in the Primary Market” reporting series from the Climate Bonds Initiative, seems to indicate that green bonds are sometimes indeed priced with a greenium.

    Another aspect to consider for investors is the ESG profile of the underlying issuer. While a green bond can ensure that the proceeds are used to finance climate-related projects, it does not shield investors from headline risks or from the issuers’ involvement in certain controversial business activities. Moreover, an issuer with a poor track record on ESG risk considerations might not be as credible and effective in its green bond issuance program as an issuer with a more robust ESG profile.

    How can and do ETFs gain exposure and invest in green bonds? 

    As a starting point we could use the Bloomberg MSCI Global Green Bond Index (launched in 2014) and which can serve as proxy for the green bond market issued by investment grade issuers. A key design feature of this benchmark is that MSCI ESG Research independently evaluates the bonds to determine if they are adhering to ICMA’s Green Bond Principles, providing a more credible set of eligible bonds.

    Comparing the Bloomberg MSCI Global Green Bond Index to the Bloomberg Global Aggregate Index (from which it is derived) shows how the universe of green bonds differs from the broader fixed income universe. Regionally, we see a substantial overweight in Europe and Supranationals, whereas the US and Asia Pacific are underweighted. 

    These regional biases are also visible when looking at the breakdown by currency of denomination, most notably with EUR being overweighted and USD underweighted. From a sector perspective, the green bond universe has a larger weight in Corporates relative to the Global Aggregate universe, as Corporates have been playing a leading role issuing green bonds in recent years. Finally, the green bond universe also has a longer duration, which could be explained by the longer-term nature of certain projects financed through green bonds.

    Knowing the characteristics of the Global Green Bond Index, it is possible to add financial related as well as ESG criteria to build a more diversified green bond portfolio. For this, we can apply as a first step an issuer capping to reduce idiosyncratic risks and a 1-10 years maturity filter to reduce duration risk. We also reduce the set of eligible currencies to only incorporate major currencies such as USD, EUR or GBP. In a second step, to screen out issuers with a poor ESG profile or involved in ESG controversies, we apply minimum thresholds on MSCI ESG Research’s ESG ratings and ESG controversies scores. In a third and last step, we exclude a set of business activities to prevent any exposure to certain controversial activities.

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