Investors must draw a line between investment impact and return.
As the exodus from fixed income markets gains momentum in favour of equities, there is one new bond that’s turning heads. Bonds that fund clean energy projects are gaining popularity from China to France to Canada.
Though still unfamiliar to most investors, green bonds — investment products that have been created primarily to boost the development of renewable energy projects that slow carbon emissions — have popped up on the world’s fixed-income stage.
The bigger hope is that these investments, also known as climate bonds, will support a flurry of clean energy technologies being rolled-out worldwide. Although the bonds can vary depending on the issuer and even the country where they are issued, they usually raise money to finance a low-carbon project offered by the issuer. For example, The World Bank lists each green bond project online, including objectives and financials, where anyone can track its progress.
Green bonds are constructed in a similar way to plain vanilla bonds; maturities last from three to 25 years and investors receive a fixed yield. Most are issued in dollars, Euros and yuan. So there’s less currency risk for investors in those regions, since they don’t have to exchange one currency for another to buy the bonds. And, unlike stocks, investors usually don’t take on risk for funding experimental projects, since the bonds are often backed by big banks.
“So investors won’t see late green bond payments or defaults,” said Chris McKnett, head of ESG investing at Boston-based State Street Bank Global Advisors. “This is important since the green space is still very experimental.” Green bonds are also usually safer and less volatile than green stocks. The reason: 89% of green bonds are investment grade, according to Climate Bonds Initiative.
A growing appetite for green bonds is prompting issuers to release a larger volume in Europe, the US, Canada and elsewhere – although the product itself is only six years old and there is no index yet to track their performance. The NGO Climate Change Initiative, however, expects to offer one next year.
In the US, Massachusetts was the first state to issue green, tax-exempt municipal bonds in June to fund energy conservation projects, such as improving energy efficiency in state buildings and protecting open spaces. And even Warren Buffett has gotten into the act. The subsidiary of Warren Buffett’s company Berkshire Hathaway called Mid-American Energy Holdings sold $1 billion worth of its bonds to build solar farms in California. The bonds have coupon yields over 5% and mature in 2035.
Pension funds including the Third Swedish National Pension Fund, along with TIAA-CREF and CalSTRs in the US, are snapping up the green bonds, along with new mutual bond funds like the Calvert Green Bond Fund.
For now, though, big global players like the World Bank, European Investment bank and International Finance Corporation are among the biggest issuers globally of these new bonds.
There are currently $346 billion in green bonds outstanding, signalling that investors are still holding them and haven’t cashed them in yet, according to the non-profit organisation Climate Bonds Initiative, which promotes low-carbon investments. Though still a tiny market, new issues were up 25% in 2012; this year’s new crop of green bonds is even stronger, according to the Climate Bonds Initiative.
Sean Kidney, chief executive officer at the Climate Bonds Initiative, predicted that the number of new, available green bonds worldwide will double in the next 12 months, as consumers add them to their green portfolios. “One advantage is that green bonds are simple to understand,” he said, “and investors can have a secure, low-risk investment.”
The World Bank mainly got the ball rolling when it issued the first bonds. Since then, the bank has issued over $4 billion green bonds used to finance low-carbon projects in 19 countries. Many funds like Calvert Green Bond Fund, include a heavy dose of World Bank bonds in their green bond mix.
One World Bank-financed project raised $30 million to turn irrigation water into much-needed drinking water in Tunisia, where aquifers are getting drained. Another one in China protects people from flooding and treats wastewater flowing into rivers. Each project is listed, and tracked, on the World Bank site.
“The World Bank makes sure that the money raised is going where it’s supposed to,” says Timothy McCarthy, author of the upcoming book The Safe Investor. “The bank’s disclosures are outstanding.”
The dark side of green
Despite their high ratings and transparency, green bonds do have their downsides. No benchmark index exists to tracks performance. Offerings for investors are still limited. In some cases, it is difficult to discern exactly how green a project is. And green bonds are low yielding: the majority yield under 3% according to Climate Change Initiative.
“Yields are higher than [US] Treasuries, but are still pretty low,” says Vishal Khanduja, a taxable fixed- income portfolio manager at Calvert Investments. “Investors must draw a line between investment impact and return.”
The bonds also lack liquidity, said McKnett. Green bonds are still a small space, he explained, and there isn’t a lot of secondary trading, where bonds can be resold. Most green bonds mature in three to seven years. “So, they’re strictly buy and hold bonds,” he added.
US green bond funds are even harder to decipher, at least when it comes to what is considered green. For example, Calvert’s Green Bond fund also invests in corporate fixed-income bonds or even bonds issued by Fannie Mae for energy saving programs for multi-family homes. “There’s no solid definition of green worldwide,” said Khanduja.
Follow BBC Capital on Facebook. Follow us on Twitter @BBC_Capital.