The five shades of green (bonds) Sustainable or green? It all boils down to intent.
By MARK HULBERT
The five shades of green (bonds)
Sustainable or green? It all boils down to intent.
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(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)
CHAPEL HILL, N.C. (Callaway Climate Insights) — Nothing is simple when it comes to investing in green bonds.
I’m referring to those corporate bonds whose proceeds are dedicated to eco-friendly projects. I had suggested in late November that you should consider these bonds if you want to have a “direct” and “obvious” impact on inducing companies to become more climate friendly. Though that is true in theory, I have since discovered that — in practice — nothing about green bonds is “direct” or “obvious.”
There are at least five types of bonds that all fall loosely in the category of green bonds, and the distinctions between them are subtle and sometimes in the eye of the beholder. Though the markets for these bonds are largely unregulated, the International Capital Market Association (ICMA) — a trade association of financial institutions — has created a set of voluntary guidelines for each type of bond.
Consider the distinction between Green Bonds and Social Bonds: The issuer of a Green Bond commits to using the proceeds to become more eco-friendly, while in the latter case the issuer commits to using the proceeds on projects with positive social outcomes. But this distinction often breaks down in practice. Doesn’t promoting environmental projects have a positive social outcome.
The ICMA acknowledges this difficulty, writing that “It is understood that certain eligible Green Projects may have social co-benefits, and that the classification of a… bond as a Green Bond should be determined by the issuer based on its primary objectives for the underlying projects.”
This classification challenge becomes even trickier when it comes to so-called “Sustainability Bonds.” These are bonds that, according to the ICMA, “intentionally mix Green and Social Projects.”
Intent and outcomes
It all boils down to intent, in other words. If a corporation issues a bond focused on promoting the environment that, as one of its unintended side effects, also has a positive social outcome, then it’s a Green Bond. But if the issuing corporation intends that social outcome, then it’s a Sustainable Bond.
Then there’s something called the “Transition Bond.” According to Ryan Riordan, a finance professor at Queen’s University, “transition bonds are a new class of bonds, the proceeds of which are used to fund a firm’s transition towards a reduced environmental impact or to reduce their carbon emissions.” That sounds a lot like a Green Bond, of course. The distinction is that Transition Bonds can be used by companies that are mostly non-green and which therefore don’t yet meet the criteria for being able to issue a green bond. An example that Riordan gives is “a coal mining firm may issue a transition bond to finance efforts to capture and store carbon.”
Investors have yet to glom on to the idea of Transition Bonds, partly because they are so new. But another reason Transition Bonds haven’t caught on is that helping a dirty company become less dirty doesn’t have the same appeal as investing in a green company. My advice is to resist that reaction. If your goal is to mitigate climate change, you may very well do more good by helping a huge emitter of greenhouse gasses reduce its emissions than lending your money to a company that is already green.
Use of proceeds bonds
All four of these bonds are so-called “use of proceeds” bonds, in which the bond issuer commits to using the capital raised for specific purposes. This is a potential Achilles’ Heel of these bonds, since the companies face few repercussions other than reputational damage if they don’t complete the projects for which they are raising the capital or, even worse, divert the proceeds to some other project entirely.
This is one reason why evidence for a so-called “greenium” has been so elusive. I’m referring to the lower interest rate that green bonds should — in theory — be able to pay relative to non-green bonds that are otherwise comparable. As I wrote earlier this year, this greenium appears to exist primarily for corporations after they have issued multiple green bonds over time — and shown investors that they can be trusted to use the proceeds of green bonds for the purposes they had promised.
To reduce your vulnerability to greenwashing, therefore, you need to convince yourself that the company issuing a bond really means what it says. Otherwise, it might be a good idea to avoid green bonds that are the first of their kind from the corporations issuing them.
Sustainability-linked bonds
This brings me to the fifth kind of green bond, which was created as an alternate way of punishing corporations that don’t use the bond proceeds for the purposes to which they committed: Sustainability-Linked Bonds (SLBs). These are not “use of proceeds” bonds but, instead, bonds whose interest rate is tied to achieving certain sustainability-related goals in the future. An example might be a company committing itself to becoming carbon neutral in 10 years’ time. It could issue an SLB that matures in 10 years whose interest rate is dependent on meeting that goal. If it does not, it would have to pay a higher interest rate on the bond.
This approach is great, in theory. But, as I wrote in a column last year, many SLBs have been issued with so many loopholes as to make them worthless. For example, more than half of SLBs have been issued with a call feature, meaning that the corporations can redeem them before maturity — and before having to pay a penalty for failing to achieve its goals. And that’s just one of the loopholes.
As a result, many investors have soured on SLBs. That’s a shame, since in theory SLBs provide an ideal mechanism for the market to regulate corporate behavior. But for that to happen, you have to be extremely vigilant that the SLB in question is issued with the proper requirements and safeguards. Being classified as an SLB is not nearly enough; we have to do our homework.
In the meantime, though, SLBs represent a shrinking proportion of total bond issuance in the green and brown space—as you can see from the chart below.
Green bond funds
Clearly, you need to do your homework before purchasing a green bond or any of its cousins. There’s no guarantee that, just because of a bond’s classification, your purchase will incentivize the bond’s issuer to behave in the way you want.
One option is to invest in a mutual fund or ETF that invests in such bonds, in effect paying the fund manager to do your due diligence. An additional upside of using a fund is diversification, since you will be investing a portfolio of many bonds rather than just one or two.
One downside of this fund approach is that you don’t get to pick and choose the particular green bond in which you would want to invest. Take the Calvert Green Bond fund (CGAFX), which is one of the largest and longer-lived funds in the green bond space. According to the fund’s website, the fund does not limit itself to investing in bonds labeled “green.” Instead, it “focuses on three broad types of issuers: green projects, solutions providers, and environmental leaders.” Its largest holding currently is a Bank of America bond.
Another downside of using a fund or ETF is that you lose the direct connection between your money and the green projects of the company issuing the bond. That’s because, when you invest in a fund, its manager typically will purchase additional bonds of those that the fund already owns — which were issued previously. The fund’s purchase with your money therefore does not go to the company itself, but to other investors who owned the bonds in the secondary market.
Your money still has an impact, let me hasten to add. But it’s indirect, via adding liquidity to the market for green bonds and thereby encouraging more companies to consider green projects for which they otherwise wouldn’t be able to find financing.
Who said that investing in green bonds would be easy?
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