In the age of environmental awareness and corporate social responsibility, green bond funds are becoming more attractive to investors.
As the name implies, a green bond is a bond whose proceeds are used to finance environment-focused projects. This relatively new segment of the bond market collects proceeds for projects related to energy efficiency, clean water, habitat restoration, combating climate change and other related matters. While many bond funds invest a portion of their proceeds in environmentally-friendly projects, a green bond fund is solely committed to these initiatives.
Green bond funds usually carry the same credit rating as the issuers’ other outstanding debt obligations, which means environment-focused projects do not necessarily involve more risks than traditional bonds.
Interestingly, the World Bank was the first organization to issue a green bond back in 2008. The international finance institution has since issued over $3.5 billion in debt aimed specifically at combating climate change.
Ginnie Mae and Fannie Mae have embraced this model by issuing mortgage-backed securities with the “green” label. U.S. municipalities and the European Investment Bank have also issued bonds for environment-specific projects.
Learn more about characteristics of bond funds here.
Benefits of Investing in Green Bonds
Like any other fund, investing in green bonds offers both benefits and risks. When it comes to benefits, green bonds have the ability to generate tax-exempt income while providing the investor with the satisfaction of knowing that their entire proceeds will be used in a manner that benefits the environment.
From the perspective of issuers, green bonds attract a new subset of investors, which means higher demand for their debt obligations. Higher demand for bonds typically lowers the borrowing costs.
The market for green bonds is also growing, which means more diversification benefits for investors. Case in point: the monetary value of outstanding green bonds exceeded $41 billion in 2015 from less than $36 billion two years earlier, according to Institutionalinvestor.com. According to Philippe Le Houérou, CEO of International Finance Corporation (IFC), the global market for green bond funds totaled $155 billion in 2017. However, it is not clear which definition of green bonds he used to arrive at that total (more on that below).
Risks of Investing in Green Bonds
As a relatively new subset of the bond market, green bond funds offer limited selection. In turn, this also leads to a lack of liquidity, something investors tend to avoid when building a diversified bond portfolio. A lack of liquidity means getting in and out of green bonds will not be easy. Although this is likely to change as demand for new issuances grow, green bonds represent a tiny fraction of the global bond market.
Liquidity and selection constraints also mean that green bonds are more appropriate for investors who are willing to hold the fund until maturity. Bond investors who like the option of selling their holdings before maturity will run into difficulty with these assets.
Another risk to consider is a lack of clarity on what exactly constitutes a green bond. As we mentioned at the outset, several funds direct proceeds to some form of environmentally sustainable initiatives but the extent to which they do so will determine whether they fall under the classification of a green bond. Investors must, therefore, perform extra due diligence when evaluating funds with the “green” label.
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Launch of the Biggest Green Fund
In March 2018, IFC joined forces with Amundi, Europe’s largest asset manager, to launch the world’s largest green bond. The Amundi Planet Emerging Green One fund closed at $1.42 billion shortly after launch, and is expected to deploy $2 billion in emerging markets over its lifetime. IFC pledged $256 million in start-up capital, while the European Investment Bank contributed $100 million.
The fund will invest in climate-smart initiatives in emerging markets, with proceeds deployed through 2025 and reinvested every seven years.
The Bottom Line
Green bonds provide an opportunity for environmentally-conscious investors to diversify their portfolios in support of an important cause. However, given the small relative size of this market, investors should tread carefully when evaluating and selecting green bonds.
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