The green bond market recently crossed the USD 600 billion in outstanding securities, but does that make green bonds a distinct asset class in itself? In the first article of this three-part series, we explain our view.
- Correlations with other asset classes
- An idiosyncratic risk-return profile?
- Any characteristics that set green bonds aside?
Investors use asset class allocations to navigate around risk diversification and returns in a particular market environment. Allocations vary depending on an investor’s assessment of the environment now and in the future over different time horizons.
Exhibit 1: Annual green bond issuance volume (USD million)
Source: Climate Bonds Initiative, BNP Paribas Asset Management, October 2019
Green bonds: Correlations and risk-return
However, there are no universally accepted criteria to define exactly what an asset class is. Yet, there are common principles that underpin classification methods.
- Different asset classes should not have high correlations. If two asset classes are highly correlated with each other, allocating to both classes will not mathematically diversify away portfolio risk.
- Within an asset class, securities should behave similarly in terms of risk and return characteristics. For example, for 10-year US non-financial corporate credits, a higher rated bond should have a lower coupon vis-à-vis a lower rated bond since higher credit risk will require a higher interest rate.
While investors will generally agree broadly on the two notions, how they actually interpret ‘high correlations’ and ‘similar risk and return characteristics’ can differ in real life.
Green bonds: Differences and similarities
In this light, we think green bonds are not a distinct asset class at this point. Most green bonds in the market today are ‘use-of-proceeds’ bonds, instead of pure project finance bonds. For most green bonds, the proceeds are earmarked for the specific activities of an issuer, and these activities are meant to generate an environmental benefit (thus ‘green’).
But repayment comes from the entire balance sheet of the issuer (as with any regular non-green bond), and not specifically from the revenues from the green activities financed (if they generate any revenue at all). Essentially, ‘use-of-proceeds’ green bonds are credit-risk equivalent to – so, not different from – their non-green bonds equivalents.
That also means that theoretically, we can have a green bond equivalent of any existing non-green bond. Both the green and non-green bond equivalent will have the same fundamental credit risk, duration risk, liquidity risk, option risk, etc.
The differences between the green and non-green bond are that
- green bonds will require proceeds to be directed towards green activities
- the issuer commits to disclosing to the market post-issuance the actual use of the proceeds (and potentially the quantified environmental benefit).
Both differences do not change the fundamental structure of the bond nor the issuer’s credit risk.
So, a distinct asset class or not?
Accordingly, we should expect the financial risks of green bonds to mirror exactly those of non-green bond equivalents. We should also expect the risk-return profile of green bonds to behave in the same way as that of their non-green equivalents.
Hence, we think green bonds should not be considered as a distinct asset class, but as regular bonds from a financial risk and return perspective, and consequently from an asset class allocation decision perspective.
Yet, we acknowledge a peculiarity about some green bonds. They can enjoy a “greenium”, in some instances in the primary market, and in others in the secondary market. Does this peculiarity change how we see green bonds as an asset class? We will define ‘greenium’ and explore this question in part 2.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.