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Do ‘greeniums’ make green bonds into an asset class? (2/3)

Some green bonds enjoy a ‘greenium’[1]. In the second article of this three-part series, we discuss this premium and whether it makes green bonds a distinct asset class.

  • The premium that is the ‘greenium’
  • Are some bonds greener and do they therefore earn a ‘greenium’?
  • The key factor is – selective – investor demand

In real life, issuers do not launch a green bond and non-green equivalent simultaneously. This makes observations of a ‘greenium’ nearly impossible. Estimating a non-green bond equivalent, researchers from the Climate Bond Initiative[2] found that some green bonds enjoy ‘greenium’ of mostly less than 10bp both in primary and secondary markets (see Exhibit 1).

Exhibit 1: Green bonds appear to do well in the secondary market, with at least half achieving better spread compression relative to comparable bonds (i.e. earning a ‘greenium’)

Exhibit 1: Green bonds appear to do well in the secondary market, with at least half achieving better spread compression relative to comparable bonds (i.e. earnings a ‘greenium’)

For a sample of EUR bonds; pricing of the bond (green dot) 28 days after issuance relative to the matched index (red) and a basket of plain vanilla bonds (blue); H2 2018 data; source: Green bond pricing in the primary market. The above securities are mentioned for illustrative purposes only; this is not intended as solicitation of the purchase of such securities, and does not constitute any investment advice or recommendation.

Some academic studies[3] have applied regression techniques to dissect the yield spreads of green bonds to identify any presence of a ‘greenium’. However, we cannot explain this in terms of credit risk since the issuer’s balance sheet is the same for a green and a non-green bond. Even if an investor believes the credit risk of a green bond issuer to be lower due to their more sustainable business model with more green activities and green assets, this applies equally to a non-green bond equivalent by the same issuer.

Investor appetite for green bonds

The only plausible reason we see for a ‘greenium’ is excess investor demand relative to the volume issued. This is not a question of lower financial risk: the risk of green bonds should match that of non-green bonds by the same structure. Any pricing differential between a green and non-green bond would be quickly and rationally arbitraged away in the secondary market. In addition, investors would not bid above the fair price in primary markets.

Therefore, a ‘greenium’ can only exist and persist if there is more money chasing green bonds than the volume issued. For example, an issuer launches a USD 500 million 5-year green bond. Fortunately, there are more primary market bids for this bond than for an equivalent non-green bond. This leads to a ‘greenium’ in coupon pricing. In the secondary market, there is also more demand than supply from those bondholders who are willing to sell at the non-green bond’s current market price. Hence, the price for a slice of that green bond rises to above that of the non-green bond until holders are willing to sell.

In reality, much more is happening (e.g. book-building momentum, price discovery, etc.), but that does not change our general explanation.

Unfortunately, we cannot identify who contributes to the aggregate demand and why. It could come from dedicated green bond funds, regular investors looking to ‘green’ their bond funds or investors genuinely looking to finance green activities. Until bond markets employ radical transparency technology, all we can observe today is this excess demand.

Do ‘greeniums’ not make green bonds a distinct asset class?

Given that securities within an asset class should have similar risk-return profiles, the answer is ‘no’. ‘Greenium’ are only for some green bonds, and some issuers. Research found a ‘greenium’ in third-party verifications, repeat issuances, certain countries, and certain sectors.

We could divide all green bonds into smaller buckets to categorise them as an asset class from a ‘greenium’ perspective, but that means the amount of investable securities per bucket will be too small for any investor’s portfolio from a risk diversification perspective.

So also in this respect, green bonds should not be considered a distinct asset class. And in future? We can assume that aggregate demand for green bonds will rise faster than supply. If we stretch this scenario to its logical extreme, there will be greeniums for any green bond relative to its non-green equivalent.

Selective demand means selective ‘greeniums’

In such a scenario, any green bond would have a distinct structural feature, and green bonds would become a distinct asset class. However, we do not see this today. Research from Credit Agricole Commercial and Investment Banking estimates that dedicated green investors hold 20% of the outstanding green bonds. Most of them are in Europe. This has led to clearer excess demand for euro-denominated green bonds relative to USD green bonds.

Perhaps dedicated green investors buy more if a bond is green rather than non-green, but this is likely for euro bonds only. So, we do not expect a general guaranteed ‘greenium’ for green bonds today.

So, how can investors treat green bonds in their allocations? We raise two possible options in part 3.

Also read:

Should green bonds be considered an asset class? What is an asset class? (1/3)

How to allocate capital to green bonds? (3/3)

[1] ‘Greenium’ refers to any premium that the issuer of a green bond enjoys in the primary and secondary market relative to a conventional bond

[2] See Climate Bond Initiative pricing reports; go here for its latest report on the January to June 2019 period

[3] See Bachelet, Becchetti, and Manfredonia, Feb 2019, “The Green Bonds Premium Puzzle: The Role of Issuer Characteristics and Third-Party Verification” & Fatica, Panzica, and Rancan, Jan 2019, “The Pricing of Green Bonds”

This article appeared in The Intelligence Report – 26 November 2019

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