Should You Pay More for Green Bonds?

Published by: Natixis Investment Managers

‘Greenium’ is shorthand for ‘green premium’. When applied to fixed income investments, like bonds, the ‘greenium’ describes the difference between the yield of a ‘green bond’ – the ‘yield’ being a measure of the income returned, or earned, on the investment – and the yield of a conventional, non-green bond from a similar issuer.

What this amounts to is lower borrowing costs for issuers of green bonds, and higher costs for their investors. It is, essentially, the way that ‘price’ is assessed in the green bond market.

Conversations about the greenium have arguably come about as a result of the rising popularity for ESG investing more broadly over the past five years1.
Many investors want to have a positive impact on environmental factors, particularly on climate action11, and, in the search for integrity, a number of funds have been converting to green labels. Stocks have traditionally led this revolution, but there has been an increase in demand for green bonds of late too2.

Some have observed that the increase in dedicated green bond mandates means a growing number of investors have become forced buyers of a concentrated number of deals, pushing the prices up regardless of the financial characteristics of the offering.

Yet others argue that a greenium is justified in some cases because the green label can be a proxy for good management, increased disclosure, and a clear, long-term business strategy at an issuer – essentially, the G the ESG (environmental, social and governance). And if these are things that an investor ultimately wants from their green investment, then paying the premium makes a lot of sense.

Either way, the gap has been narrowing between what investors are willing to pay for green bonds versus more traditional bonds. In Europe, which boasts the most developed green bond market, the greenium has shrunk from over 9 basis points (bps) in 2020 to between 1 and 2 bps in 20223.

The return of inflation, high commodity prices and higher interest rates have meant issuers of both green and conventional bonds have withdrawn somewhat this year4.

Research has found that the risk-averse environment that has caused a wider yield differential – the ‘credit spread’, or difference between the return of two different debt instruments with the same maturity but different credit ratings – should benefit green bonds, which are often more robust than conventional bonds under such conditions5.

It equates this positive assessment to the more defensive profile displayed by the green bond universe, their popular ‘impact’ characteristics – financing projects that contribute positively to the environmental and energy transition, such as the development and storage of renewable energy – and also their investor base, which is believed to have a longer investment horizon.

Scaled according to the issuing sector, the research says the greenium tends to be lower in sectors where conventional bonds are expected to be in a minority and replaced by green bonds5. These sectors include utilities and financials.

The utilities sector operates at the heart of the energy and environmental transition and, structurally, issues a large number of green bonds. Financials, on the other hand, have large financing needs, including the funding of many green assets – often real estate.

Cyclical sectors displayed a higher greenium, however – the consumer goods sector, for instance, is still at a very early stage in the green bond market. Car manufacturers and their suppliers, meanwhile, are issuing on a recurring basis to finance the production of cleaner vehicles.

But it’s in sustainability linked bonds (SLBs) where the largest growth in issuance volumes have been seen in recent years55 – and where there’s the most potential for competition with green bonds.

The use of proceeds of green bond investments might be linked to environmental projects – say, renewable energy installations. But with an SLB, the coupon payment itself is actually linked to the sustainability performance of the issuer – lower greenhouse gas emissions, for instance.

The issuer of an SLB can therefore use the proceeds for general purposes and is not required to track the projects funded by the issuance. This flexibility afforded to the issuer – in that they have the freedom to choose how they intend to achieve their sustainability targets – makes SLBs highly attractive. After all, any company can issue an SLB, whereas the same cannot be said of a green bond.

Sectors that issue large amounts of SLBs relative to green bonds will widen the greenium. Examples include industrials – with the exception of the car industry – and consumer goods, as well as the pharmaceutical and technology sectors. In contrast, current regulations stipulate that the financial sector – and banks in particular – cannot issue SLBs.
In short, the emergence of SLBs could slow down the growth of the green bond market, preventing the greenium from shrinking in some sectors.

The emergence of SLBs as competition for green bonds, a positive interest rate environment and updated credit ratings (including downgrades) for indices and the overall bond universe may all be contributing factors that catalyse the greenium in the months ahead.

Moreover, the renewed focus on ‘greenwashing’ – SFDR came into force in Europe last year, while the SEC has proposed similar rules in the US – and closer regulatory scrutiny, may result in a more robust greenium for select issuers.

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