The bond "greenium" | Pass or play?
Having launched the first corporate-focused green and sustainable bond fund in Australia, a common question posed to us is in relation to the current green premium or “greenium” attached to green bonds.
Essentially, why pay more for a green bond when the credit risk is the same on a non-labelled bond? Is this a financial fad, and in the long term are investors better to stick with non-labelled bonds as the greenium fades?
Firstly, what exactly is meant by “greenium”? It is the perceived premium in price and forgone yield a bond investor will pay to buy a green bond over a regular – or may we say – “brown” bond. Green bonds are standard bond issues that apply all the proceeds to documented green projects or initiatives. In global bond markets, the European market exhibits the most notable greenium according to our analysis. In other markets it is less pronounced, or not consistently observable at all. We have observed some new euro green bond deals pricing 0.10% to 0.15% lower than their brown bond curve. Considering the outright yields in Europe (some corporate bonds have a negative yield), the greenium investors are willing to pay is meaningful.
So why are investors continuing to pay this greenium?
The rational answer is that they need the bonds for mandate requirements. Investors want their capital deployed in the fight against global warming – and the climate challenge can only be met with massive financial investment in carbon-reducing infrastructure combined with technological advancements. This is beyond simple financial motivation and causes a technical spike in prices. Demand for green bonds, therefore, in relation to brown bonds, is usually greater (especially when an issuer only issues one green bond on their credit curve). The law of supply and demand tells us that supply will eventually catch up to the new demand and prices will track back to the same price as other bonds issued by the same company. The credit risk is no different; if a company defaults, whether holding green or brown bonds, an investor has the same credit risk and exposure. However, what is unique in the supply and demand imbalance, is that there aren’t infinite green assets to be financed. Not every issuer has a green asset they can invest in, yet one could argue almost all issuers can make their businesses more sustainable and environmentally friendly. So, will green bonds become rarer as a percentage of total issuance, as more issuers naturally turn to sustainable bond issuance? This is quite possible as sustainable bonds have a broader use of proceeds - targeting one or more of the 17 Sustainable Development Goals.
There is also a more subtle reason why the greenium is stubbornly in place. A rational investor will also buy expensive assets if they believe they will become even more expensive. Alternatively, investors will shun cheap assets if they see them becoming cheaper. Leaving aside the investor who buys a bond and has no plan to sell in the next 10 years, there are many that see there are capital gains to be made by playing the “technical“ shorter-term demand play. This type of investor behaviour feeds the positive greenium dynamic. It is important to note there are many technical drivers at play that cause temporary or entrenched price differentials in bond curves – it is not unique to green bonds. In all cases, it is a potential opportunity for the active investor.
Lastly, European Union governments and regulators are tinkering with financial incentives for companies who are making an impact on carbon emissions. There is the possibility that green bonds could be treated better than brown. In this case, there will be a measurable financial benefit and a greenium will be a permanent feature. Rational investors may be pricing in these potential developments, further justifying a greenium in the current euro markets.
Paying for what's good for you
The more important question is not what is happening – that is easy to answer – but how long will these pricing relationships remain? When will this technical play out? How long will we be in this stage – days, months or even years? There is also the fact that not all green bonds have the same impact. Some have rigorous oversight and high carbon impact whereas some are guilty of greenwashing. Over time investors will become more discerning and the technical strength or greenium will only be sustained for those bonds deemed to be best in class and whose use of proceeds are, dollar for dollar, making the most measurable impact. Just like all cereals are not the same – the health-conscious will pay more for muesli than Coco Pops – motivated investors will pay more for a green bond that reduces carbon emissions than one that is being used for general corporate purposes. Those who analyse these differences closely should generate higher returns over time as demand should be stronger when a company is delivering on more ambitious carbon objectives. Under these conditions, the greenium may well be sustained for high quality issuers who are committed to their defined use of proceeds.
Macroeconomic, regulatory and societal forces are all playing their part to create the greenium in some markets. It could be argued that Europe is leading the way in creating a two-price tiered market and investors would be well served by buying green bonds in other markets as they follow Europe’s lead. All investors, (whether or not they have a special impact mandate like Artesian) will primarily make a decision based on the likelihood of green bonds outperforming non-labelled bonds. If this is the case, be prepared for other markets to start showing a greenium and those investors with access and emphasis on these markets, to continue to outperform. When the greenium is most pronounced, it is important to be particularly discerning and invest in those bonds that actually have a defendable case to trade at a premium. Or invest in a fund that can be discerning on your behalf.
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Matthew is one of the Founding Partners at Artesian Capital Management, which was created in 2004. In addition to running Artesian’s global corporate bond business, Matthew spends the majority of his time as CIO of the Artesian Corporate Bond Fund.