How Advisers Can Add Green Bonds to the Portfolio Mix

The green bond market is expected to hit the $1 trillion mark soon. Here’s how advisers can use green bonds and ETFs to deliver diversification.
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There can be no denying that there’s been rising global interest in environmental, social and governance (ESG) investing.

And that interest is leading to greater and greater assets under management.

The Forum for Sustainable and Responsible Investment, for instance, estimates that there’s $17.1 trillion in sustainable investments in the U.S. which represents 33% of the $51.4 trillion in total U.S. assets under professional management.

And some of those assets are invested in green bonds, and those assets are expected to grow dramatically.

According to UBS,  (UBS) - Get Report the green bond market is expected to hit the $1 trillion mark soon. In 2020, over USD $400 billion worth of environmental, social and governance (ESG) labeled bonds were issued—including $215 billion worth of green bonds, $133.5 billion of social bonds and $61.4 billion of sustainability bonds.

But should you add such investments to your client’s portfolio?

“I think green bonds can be a sensible addition to portfolios for clients who are concerned about risks especially related to climate change and/or want some positive ESG impact from their investments,” said Bob Dannhauser, senior adviser to The Investment Integration Project, which recently published in cooperation with the Money Management Institute, Fundamentals of Sustainable Investment: A Guide for Financial Advisors.

What’s more, Dannhauser said it’s getting easier to implement, given the huge flow of new issuance and growing interest by institutional investors in this space that is deepening the market and adding some liquidity.

And for individual investors, he said there are an increasing number of green bond ETFs that make sense in delivering diversification and some degree of management.

All that said, however, Dannhauser cautioned investors and their advisers to keep in mind the following:

Fixed income only works if you get repaid. “Don’t let the green label blind you to credit risks,” he said. “Most green bonds are use-of-proceeds with recourse to the issuer’s balance sheet, but there are other flavors too including revenue bonds, project bonds, and securitizations.

While it seems pretty rare still, Dannhauser said it isn’t hard to imagine issuers using the green label as “the lipstick on the shaky-credit-pig.” Regulators, he said, seem determined to not fall behind in addressing issuer “greenwashing” but regulatory frameworks are still evolving.

UBS noted in a recent report that green and non-green bonds, from a financial point of view, represent the same creditor claim on the issuing entity and should theoretically offer the same yield.

“Due to strong demand and a more diverse and longer-term-oriented investor base, green bonds have shown relatively good resilience during volatile market periods,” UBS wrote. “But over time we think investors should expect similar financial returns.”

From a sustainability point of view, however, UBS noted that “green bonds provide greater transparency for investors with a focus on environmental issues, while also enabling them to build a specific portfolio exposure. Buying green bonds also sends a strong signal to the issuer and market participants that specific environmental topics matter.”

The “greenium” is real. According to Dannhauser, the premium investors are apparently willing to pay for green bonds lowers costs for issuers.

“This probably is a reflection of the huge demand for ESG assets these days, but it might also reflect more nuanced consideration of how green projects reflect management’s effective addressing of risks, especially environmental risks,” he said.

For the investor who really doesn’t care much about the ESG impact, Dannhauser said advisers should be prepared to discuss why – or if – the premium associated with these investments is worthwhile.

For its part, UBS noted the following about the greenium: “The green bonds of some prominent issuers are trading at a small 'greenium,' i.e. a slightly lower yield than for comparable non-green ones, but these are exceptions right now. Most green bonds trade fair on the issuer’s yield curve, and we think such scarcity premiums will remain small at just a few basis points. The 'greenium' would also fade as issuance rises.”

Dannhauser also said the ‘greenium’ is also relevant to the risk of greenwashing, in that issuers may be motivated to conjure a green story to accompany their bond issuance to reduce costs.

UBS, for its part, “thinks such cases of greenwashing only form a small portion of the market, and as regulation and external reviews become more prevalent, incentives for issuers to attempt greenwashing should diminish.

Pay attention to diversification in collective investment vehicles like ETFs. The universe of green bonds is still not as diverse as the full spectrum of fixed income, said Dannhauser. “And while investors can choose from well diversified green bond investment products, it is still good practice to be sure that country and sector concentrations fit with your view of the risk landscape and the rest of your portfolio,” he said.

Bottom line? “Overall, we think green and ESG-labeled bonds are among several sustainable strategies that will play an even bigger role in the coming decade,” UBS wrote. “As governments and businesses alike place an increased emphasis on sustainability over the coming years, we think systemic consideration of all relevant ESG factors can help investors navigate uncertainty and position for the long term.”

Read UBS’s last report on green bonds and read UBS’s report about buying into sustainability.