Did you see our recent post about net zero? As a quick recap, we see it as one of the great challenges of this century, for governments, citizens, and everyone in between.
Achieving net zero means global carbon neutrality, where any greenhouse gases emitted are cancelled out by those removed with new technologies and new habits. It requires a major shift in how investors allocate capital, and how they engage with companies to turn well-meaning ideas into action.
Today we’re going to explore one option that investors have to start their own climate transition. This involves mobilising some of the $125trn accumulated in the global bond market1. That’s a lot of money stored up, ready to deploy.
We’re talking about ‘green bonds’, a relatively new but booming segment of the bond market. Green bonds offer investors a way to direct some of their capital towards climate projects. As we’ll see, the rationale for including them in portfolios is stronger than ever.
First things first: how do they work?
Investing with purpose
When you buy a normal or ‘vanilla’ bond, you’re lending your money to the issuing company or government with no strings attached. The issuer uses the proceeds for an unspecified purpose, and pays a coupon on the bond in return. Eventually—in most cases—you get your principal (loan) back.
Green bonds, in contrast, raise money for a specified purpose. For a bond to be certified as green, its proceeds must help fund climate or environmental projects. So, unlike with a vanilla bond, you will always know where your money is going. You can think of it as financing with ‘green strings attached’.
A green bond could be financing a new windfarm, or a project to increase a low-lying town’s flood resilience, or a train station refurbishment which boosts public transport use – any of a wealth of projects that will go on to benefit the environment in a specific, tangible way.
Put simply, green bonds offer much more transparency and measurability than normal bonds. Yet they still fly under the radar for many investors. Many, that is, but not all. Away from the mainstream, the green bond market has been booming in popularity.
For investors, there are several things worth knowing about this growing segment of the market.
Why green bonds are going mainstream
Speak to any climate activist and you’ll hear the fight against climate change is slow – too slow. One reason why is because climate projects need to be financed, and there hasn’t been a good mechanism for connecting investor cash with the green projects that need it most.
Let’s consider for a moment what climate-action or mitigation projects involve. This could be capital expenditure for new infrastructure, or major changes to existing systems, or investment in developing technologies. It all costs money, and sometimes that money is hard to find.
Green bonds open up a channel to deliver much-needed funding
directly to green projects.
But it’s not an act of charity – these are investments, and so they come with a return. Just like their vanilla counterparts, green bonds pay a coupon. After all, a windfarm will generate and sell electricity. A new transport hub will process thousands of paying passengers. Flood resilience is worth paying for today if it reduces future costs. Investing in the energy transition is still investing.
That’s why, even putting environmental concerns aside, green bonds can be an attractive investment. They offer returns and diversify portfolio risk while contributing to climate action in a measurable way. And they are being rapidly snapped up by investors waking up to the fact that environmental benefits don’t have to come at a premium.
Investors are waking up to the potential
Green bonds are still a small part of the giant global bond market, but they’re on a very strong growth trajectory. The left-hand chart below shows cumulative labelled green bond issuance globally. This crossed the $1.5trn threshold in 2021, having hit $1trn as recently as 2020.
The right-hand chart shows cumulative flows into green bond ETFs domiciled in Europe. We can see a similar shape emerge, one which has been referred to as exponential growth by Climate Bonds Initiative, an organisation mobilising capital for climate action.
The issuer mix for green bonds (the proportion of green bond issuers that are corporate, sovereign, local government, etc.) is very different from the overall bond market. Just 13% of total issuance is from sovereign issuers – national governments – versus 59% in the global bond market. The reverse is true for corporate issuance: 49% of green bonds are issued by corporations, versus 19.5% in the global bond market.
We believe sovereign green bond issuance will rise further, bringing the issuer mix closer to what we see in the global bond market and increasing the size and diversity of the bonds on offer to investors. More national governments have been testing the market, including 2021’s new entrants, the UK and Sweden. The UK issued its first green Gilts of £10bn and £6bn, becoming the largest issuer of 2021 and catapulting itself straight into the top 10 issuers by amount outstanding.
This funding will be used to finance vital green government projects across the country, including things like clean transportation, renewable energy and preserving our natural environment. In helping us to build back better and greener, it will also help to create jobs as we transition to net zero.
With energy independence and security rapidly climbing the governmental agenda, even more may decide to issue green bonds to finance the transition, rather than rely on external fuel sources or less direct funding. That could create an interesting evolution of the market and offer new opportunities for fixed income investors.
Positive investing with a green bond ETF
Green bonds are a way for investors to get more certainty about the outcome of their investments. With “use of proceeds” rules, they can be sure they’re funding green projects.
It means green bonds are both a powerful and positive investment. For all the alarming statistics on global warming, humanity still has a big opportunity to limit climate change before it’s too late. Scientific research has determined +1.5°C as the point after which there would be a significant negative impact on the environment. There’s a phenomenal amount of investor cash that could be mobilised to help keep warming at or below 1.5°C.
Green bonds provide a route forward to shift those trillions into projects where they will make the most difference.
Of course, for most people it’s not practical to buy and sell individual green bonds. That’s why specialist green bond ETFs bring together labelled green bonds and provide them for investment in a simple ETF wrapper. The Lyxor Green Bond (DR) UCITS ETF (ticker: CLIM) is the original, and still by far the largest with €613 million under management2.
We measure and report on CLIM’s allocation of proceeds. In 2021, the top three sectors to receive proceeds from the Lyxor Green Bond (DR) UCITS ETF were Energy (36%), Green Buildings (26%) and Clean Transport (20%)3.
Electricity and heat production from renewable sources, transmission and smart grid infrasctructure, energy storage (...)
Construction of refurbishment of tertiary or residential buildings with low energy consumption certification (...)
Rail transport systems for merchandise or passengers, electric or alternative fuel vehicles, bicycle infrastructures (...)
Please note: The approach implemented by the Lyxor Green Bond (DR) UCITS ETF by investing in green bonds is largely based on third party data that may be incomplete, inaccurate or unavailable from time to time, and which make it dependent on the quality and reliability of such information. Investment in green bonds may also induce sectoral biases in the global bond market. For more information, please refer to the prospectus of the fund.
How to add green bonds to your portfolio
If it’s not clear enough already, we strongly believe green bonds are a crucial part of the climate transition. That’s why we offer several options for adding green bonds to a portfolio, including our industry-leading aggregate bond ETF, eurozone government green bond, and the corporate green bond ETF we launched in September 2021.
In this article, we’ve touched on the positive effect that can be achieved at a (relatively) small scale with green bonds. Now imagine what more we could achieve if the vast potential of the bond market shifted to green investments.
As the table below shows, there are more options than ever for doing well by doing good.
Source: Amundi, AUM and TER correct as at 26/8/2022. As of 1/1/2022, Lyxor ETF is part of Amundi Asset Management.
*OGC = ongoing charges (annual, all taxes included). The ongoing charges represent the charges taken from the fund over a year. Until the fund has closed its accounts for the first time, the ongoing charges are estimated. Transaction cost and commissions may occur when trading ETFs.
Please note: Investment in the UCITS ETF listed above carries with it a degree of risk including, but not limited to, risks referred in the “Knowing your risk” section below. For specific risks in relation to an investment in the relevant UCITS ETF and particularly in Green Bonds, please refer directly to the dedicated “risks warning” section of the prospectus of the relevant UCITS ETF.
1.SIFMA Research Quarterly: Fixed Income – Issuance and Trading, January 2022. https://www.sifma.org/resources/research/research-quarterly-fixed-income-issuance-and-trading/
2.Source: Amundi, AUM at 26/8/2022. As of 1/1/2022, Lyxor ETF is part of Amundi Asset Management.
3.Source: Amundi. Top three sectors by use of proceeds.