By Ulf Erlandsson, Senior Portfolio Manager Credit, Global Macro Trading, Fjärde AP-fonden/ Fourth Swedish National Pension Fund and Sean Kidney, CEO Climate Bonds Initiative.
Originally published in Institutional Investor 29.12.2014
The International Energy Agency (IEA) tells us that, on current trajectories of greenhouse gas concentration, we can expect global warming of 6-7 degrees Celcius over this century. The paleontological records of past peaks in greenhouse gases suggest we might be better calling that “global frying”. The IEA does also say, however, that we have a good chance of avoiding the worst of this if we can make a rapid transition to a low-carbon economy – which would involve some $36 trillion of global investments above business as usual to 2050.
The clock, though, is ticking fast. There are massive, productive investments (yes, they are investments, not costs) to be made in green projects; at the same time there is an over-supply of risk-taking capital at very low yields.
Green bonds have evolved as one way to bridge the supply-demand gap between debt capital markets and targeted green investment projects. In 2014, the asset class has trebled impressively to reach $36.6bn ($39bn if renewable energy project bonds are included, as Bloomberg does). Put in context, however, if we look at absolute size rather than growth rates, the green bonds market is dwarfed by an average issuance of $100bn per week in investment grade bonds alone. For example, last year Verizon raised funds to the tune of $50bn – more than the amount outstanding in the total labelled green bonds market - in one short day to fund the acquisition of Vodafone US. Why couldn't we harness such market power into investment dedicated to growing a low-carbon economy?
If you buy the concept that climate change is happening and that it will have major impact on the world’s economies, and therefore on investors’ portfolios, it's perplexing to see large investment houses dedicating often very small fractions of their assets under management to investments aligned with climate change mitigation and adaptation, such as dedicated 'Green Bond' funds. A 2% allocation to such funds draws attention to the issue, sure, but might seem skinny at best; what we need is to see the allocation of large chunks of mainstream portfolios. The risk is that dedicated green bond funds could, over time, even be detrimental to that allocation to green bonds in a mainstream portfolios. Let us explain.
Firstly, the natural switches that appear in a bond fund, which also are a natural source of trading profits, may be restricted due to the relative small size and limited diversity of the green bond market. If one trades supranational bonds such as the World Bank where there are many bonds outstanding on the yield curve, selling a non-green bond to buy a green is generally a much easier decision than buying a new green bond outright. However, such natural switching opportunities are likely not available for a wide range of bonds – they might not have a green bond equivalent. Missing out on natural switching will ultimately be costly to green portfolios, as well as impair the liquidity in the green bonds market.
Second, one of the first lessons you learn as a trader in that environment is to avoid being a forced buyer or seller of anything. Funds in the green bond space that set quantitative targets on how much they need to buy make themselves what is called ‘axed buyers’. It’s natural for banks and other market participants to reverse-engineer such forces and in the end offer worse pricing. As in poker, showing your cards clearly runs the risk of your fund underperforming versus the other players around the table. On top of that, when it comes to primary market issuance, issuers and banks can target forced buyers to make prices uncomfortably high. That then puts off market driven investors from joining green bond syndications, further dampening demand and slowing green bond market growth.
Finally, suppose a large bond fund decides to make that 2% allocation of their portfolio into green bonds, which would still considered a fairly large number in today’s marketplace. Is it likely that the best portfolio managers will be dedicated to such a small sub-fund? There is a clear danger that such green bond funds will be managed by more junior managers hence making return potentials lesser. They are also likely to have smaller risk-mandates than more senior managers, which in turns disallows to take on as much risk, i.e. buy as many green bonds. Also, these mandates tend to be more restrictive in terms of alpha potential. Allowing a portfolio manager to invest in highly liquid credit default swaps, for example, can compensate for the lower liquidity of green bonds, and so allow bigger investments in green bonds.
Constraining green bond investments to only a small fraction of a larger portfolio is likely to induce underperformance of the asset class. If that goes on over long periods, it will deter investors from including green bonds in their core funds. From a trader’s perspective, you are better incentivized to trade green bonds if you are not constrained to a dedicated Green Bond fund format. Well incentivised traders can and will be active in the market segments that can fill the Verizon $50bn in an afternoon – which is the kind of pace we need to mobilize for green bond issuance.
Besides expected performance issues, end-investors should also be aware of what sits under the hood of the investment in terms of channelling funds to the real economy, which is what we need to address the climate change issue. It's worth understanding the difference between direct and indirect impacts from green bond investors on finance in the real economy. Direct impact occurs at one point only, and that is when the bond gets issued in the primary market. The investor pays money directly to the issuer, receives the bond, and the issuer goes ahead and invests it in green projects or refinances an asset and recycles the funding into new projects.
However, something classified as a green bond portfolio, with 100% of capital invested in the asset, may have directly contributed 0% cash to green projects or re-financing, if the green bonds in the portfolio are bought on the secondary market. But buying of green bonds in the secondary market could have an indirect impact on green financing in the real economy, if the seller of the green bond re-invests the money from the trade into green bonds from the primary market. In this sense, bond investment in the secondary markets can be seen as "refinancing one-step removed". That's good.
For investors aiming to maximise their direct impact on green financing then, they should aim to maximise their investment in green bonds in the primary markets, To do that, they must roll over their green bond portfolio at a faster rate. As an example, there is a tenfold difference between the direct environmental impact of a portfolio which rolls (reinvests in primary market) its holdings twice a year versus one that rolls them every five years. End investors should be aware of this feature in their investment, if they want to have a more tangible impact on the real economy. If this is the case, green bonds should be more, not less, liquid than traditional bonds due to higher turnover than traditional bond funds. However, this process of rolling over the portfolio does require that there are investors willing to buy the bonds in secondary markets, i.e. that they are satisfied with having indirect impacts on green investment in the real economy.
So suppose the green bond space does the quantum leap and becomes the playground of your everyday bond managers, and get the potential of inflows in the trillions. What will be the challenges then?
If anything, there might be a lack of projects to fund. There is a gradual shift in corporates to thinking proactively around this, but we think policymakers and financial intermediaries can help further. There are plenty of potential green projects that may not hit internal Internal Rates of Return (IRR) targets, which may be set quite high to bring enough return on equity to stakeholders. An environmental project that looks set to produce an IRR of 10% versus required 15% might be thrown into the dustbin, although from a broader societal standpoint (accounting for environmental positive externalities) it might still be profitable.
Policymakers are going to need to bridge this gap via equity/mezzanine financing and other measures — balance sheet effective ways for constrained government budgets to get more environmental projects going. That’s the main game: the role of the public sector in mobilizing private sector capital, and doing it in a way that is balance-sheet effective and quick so that we have a chance of avoiding catastrophic climate change. If the public sector takes this role, bond markets will be there to provide the senior part of the capital structure.
Embrace and lever that willingness, our economies need it.
