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

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If green bonds are not a distinct asset class, how can investors include them in their capital allocation decisions? In the final article of this three-part series, we raise two broad options (but there is likely an indefinite number in reality).

  • Going for just green bonds?
  • Or adding them to a general bond portfolio?
  • For maximum impact, go for maximum green

Allocating capital to green bonds – option 1

If an investor is truly looking to finance green activities, a deliberate approach would be to set up a dedicated green bond fund. The risk-return characteristics of such a fund should hypothetically be equivalent to those of a non-green bond fund with the same fund characteristics (e.g. equal percentage of the assets invested in AAA rated bonds, equal-weighted average duration).

In reality, though, we can expect differences in volatility, yields, drawdowns, etc., given that not all issuers have green bond equivalents of their existing bonds. However, there are also the environmental benefits (enjoyed by society) from those green bonds on top of the materially equivalent yields from an equivalent non-green bond fund, at no material (extra) cost to the investor.

Allocating capital to green bonds – option 2

Alternatively, an investor could take an opportunistic approach to their regular bond fund and tilt their preferences to green bonds whenever possible, but without the constraint to invest in green bonds only.

Over time, this fund can become greener as the supply of green bonds scales up, but the fund does not need a deliberate objective to do so. Such a fund can pursue return objectives unconstrained by the supply of green bonds, yet choose to allocate capital to green activities at no material (extra) cost when there is a good opportunity.

Critics can argue that for the first option, the money can simply be invested in an unconstrained bond fund that seeks even higher-yielding bonds outside of the universe of green bonds. That is true, but higher-yielding bonds also mean higher financial risk. If an investor does not want a higher-yielding (risk) fund, and goes for a fund whose risk profile that can be matched by a green bond fund, then why not go for the green bond fund that has environmental benefits at no material (extra) cost to the investor?

Essentially, this is how investors shop for bond funds today. An asset manager proposes a fund with investment objectives and risk management constraints. If the investor likes it, they put their money into the fund. If not, the asset manager tailors the fund to meet the investor’s needs.

Choosing between the options

For an investor looking to invest in green bonds, the first question concerns the yields and financial risks they are expecting to carry. Can this be taken care of through a dedicated green bond fund with a materially equivalent yield and risk objectives? Does the investor want to finance green activities through that fund? If not, the investor can go with option two – an opportunistic approach.

Go for green – it is better

From an asset allocation perspective, green bonds should be considered as regular bonds within the same framework for deciding how much of a portfolio should be allocated to bonds (considering the yields and risks).

Once an allocation is made to bonds as an asset class, the investor can consider using a dedicated green bond fund approach, or an opportunistic regular bond fund approach. Of course, from the perspective of environmental benefit, a dedicated fund can achieve much more than an opportunistic approach. Still, at least both approaches can generate environmental benefits, and since we are facing a climate emergency, we need every contribution we can get.

Also read:

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

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

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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.
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Xuan Sheng Ou Yong

Green Bonds & ESG Analyst

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