ESG and Green Bonds: 9 Things You Should Know

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ESG and green bonds, also know as climate bonds, have reached in 2020 a market value of USD 1 trillion. ESG and green bonds are types of sustainable debt that allow investors to allocate capital into fixed income assets, while serving as good alternatives to de-risking the portfolio of sustainable investors.

1. What are ESG and green bonds?

ESG and green bonds are part of a broader group of fixed income called climate bonds. Climate bonds are fixed income products that are designed to address climate, social and environmental issues.

When buying climate bonds, investors are lending money to governments and corporations, and in return expect to receive financial returns in the form of fixed income (interest plus principal) during a pre-determined period.

2. Which types of ESG and green bonds exist?   

Climate bonds are comprised of four types of bonds: Green bonds, Social bonds, Sustainability bonds, and Sustainability-linked bonds (or ESG bonds):

  • Green bonds: proceeds are earmarked, and to be exclusively used to finance specific new or existing green projects. Green bonds are backed by the issuer’s entire balance sheet.
  • Social bonds: proceeds are earmarked as well, and to be exclusively used to finance new or existing projects with a positive social outcome.
  • Sustainability bonds: are a combination of green and social bonds.
  • Sustainability-Linked bonds: proceeds are not earmarked but should be used for corporate purposes aligned with ESG (environmental, social, and governance) activities. Sustainability-Linked bonds should be connected to relevant, measurable, and verifiable KPIs.
ESG and green bonds are part of climate bonds
Types of climate bonds

3. How big is the ESG and green bonds market?

The climate bonds market has reached an accumulated issuance of USD 1 trillion in 2020. The market has been through a strong growth since 2007 when the European Investment Bank issued the first green bond under the label Climate Awareness Bond.

However, the climate bonds market represents less than 0.8% of the total bond market (USD 128 trillion).

Green bonds dominate sustainable debt market. Follow by social bonds

Green bonds are the largest category among climate bonds, accounting for almost USD 300 billion sales in 2020. Right after are Social bonds, with growth driven by the issuance of pandemic-relief loans resulting in about USD 150 billion sales in 2020. Sustainability-Linked bonds and Sustainability bonds had issuances of less than USD 100 billion each during 2020.

4. Who can issue ESG and green bonds?

Most of the ESG, green bonds, and related climate bonds can be voluntarily issued by national and supranational banks and corporations that comply with the International Capital Markets Association (ICMA) standards.

The ICMA developed the climate bonds “Principles” in 2014 as voluntary process guidelines for issuing sustainable debt. Each bond category has its guideline – Green Bond Principles (GBP), Social Bond Principles (SBP), Sustainability Bonds Guidelines (SBG), and Sustainability-Linked Bonds Principles (SLBP).

The first three bond categories (GBP, SBP, SBG) are based on the same four core components:

  1. Use of Proceeds: funds should be exclusively allocated to eligible green and social projects
  2. Process for Project Evaluation and Selection: issuer should communicate project objectives and eligibility
  3. Management of Proceeds: proceeds of the issuance must be carefully tracked
  4. Reporting: use of proceeds must be reported to investors periodically

The firth and newest bond category, Sustainability-Linked Principles (SLBP), have been in implemented 2020, and have five core components:

  1. Selection of Key Performance Indicators (KPIs)
  2. Calibration of Sustainability Performance Targets (SPTs)
  3. Bond characteristics
  4. Reporting
  5. Verification

It is important to mention that social and green bonds do not always indicate good ESG ratings. Companies with low ESG ratings can issue green and social bonds for specific green and social projects (e.g., an Oil & Gas company financing a renewable energy project).

Also, not all ESG bonds follow the ICMA standards. ESG ETF bonds can be created to track ESG Indexes that might not be aligned with the Sustainability Performance Targets.

For example, iShares ESG Aware 1-5 Year USD Corporate Bond ETF (SUSB), an ESG ETF bond from iShares with a good MSCI ESG Rating (>8.0), tracks the Barclays MSCI US 1-5 Year Corporate ESG Focus Index. This index is designed to maximize exposure to positive environmental, social, and governance (ESG) factors and to exclude companies in controversial businesses. However, the index does not mention the SPTs or any sustainability KPI’s on its fact sheet.

5. Is there a “greenium”? Do green bonds have lower yields than conventional bonds?

The price difference between green bonds and regular bonds, known as the “greenium”, is extremely low and, for some investors, insignificant. Studies show that green bonds yields on average 0.15-0.20% lower than conventional bonds.

From a bond issuer perspective, the “greenium” can result in a slightly lower cost of capital, benefiting the bank or company’s balance sheet. One the other hand, this could also increase the risk of greenwashing.

The “greenium” can be explained by two main theories:

  • Sustainable investors are not solely focused on the financial returns, but also care and value the social and environmental benefits of the green and social bonds
  • Green and social bonds are associated with lower long-term risks when compared with conventional bonds, thus decreasing their chance of default.

In the long-term, with the growth and maturation of the climate bonds market, the yield of climate bonds is expected to reach parity with conventional bonds.

6. Do ESG and green bonds have better returns?

When accessing the financial performance of any bond it is necessary to investigate the total bond return, which represents the annual yield plus the principal variation in the period. As seen above the yield of green bonds can be slightly lower. However, the total return tells a different story.

BBVA compared the returns of Barclays MSCI Green Index vs. the conventional bond index in the period from 2015 to 2019. For both currencies, USD and EUR, the green bond indexes outperformed the conventional indexes by more than 1%.

green bonds vs vanilla bonds
Performance: Green bonds index USD vs. vanilla bonds index
green bonds vs vanilla bonds
Performance: Green bonds index EUR vs. vanilla bonds index

7. How much to invest in ESG and green bonds?

There are several theories of how much investors should allocate in bonds from their total portfolio. It goes from the famous Ray Dalio’s “All-Weather-Portfolio” with 55% of bonds, through the classic Wall Street recommendation of 60/40 (60% stocks/ 40% bonds) allocation, to the more aggressive 90/10 from Warren Buffet.

In the end, portfolio allocation is a personal choice and will depend on investment goals, investors age, risk tolerance, and wealth. Investors that are already investing in conventional bonds can start migrating their share of conventional bonds to ESG bonds and green bonds, increasing the positive impact of their portfolios.

Investors that do not hold bonds, can evaluate the right time to add those to their portfolio, and when that happens, give priority to ESG and green bonds.

Investors with higher risk tolerance, looking for fixed income investments, should consider impact investments, such as debt crowdfunding.

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8. Are ESG and green bonds good investments?

ESG and green bonds are good investments for sustainable investors seeking fixed income products able to reduce portfolio risk and bring positive impact to society and the environment.

Financially, climate bonds should perform at the same level or better than conventional bonds. Moreover, they offer reduced risk since it demands more transparency and accountability from the issuer. On top of that, from a sustainability perspective, ESG and green bonds send the right signal, especially to corporations, that investors are aware of their practices and demanding change.

9. The top 5 ESG bond ETFs

According to ETF.com the top 5 climate bond ETFs, raked by MSCI ESG Quality Score are:

ETF ListTickerProviderDomicileMSCI ESG RatingMSCI ESG ScoreGlobal rank /100MSCI WACI (tCO2/M$ sales)Brown revenue (%)TER (%)
iShares ESG Aware 1-5 Year USD Corp. Bond ETFSUSBiSharesUSAA7.9951333.80.12%
SPDR Bloomberg SASB Corp. Bond ESG Select ETFRBNDSPDRUSAA7.5881924.80.12%
iShares ESG Aware USD Corp. Bond ETFSUSCiSharesUSAA7.3881604.20.18%
Xtrackers Bloomberg Barclays US Invest. Grade Corp. ESG ETFESCRXtrackerUSAA7.1832365.30.24%
iShares Global Green Bond ETFBGRNiSharesUSA7.0794693.80.20%

Not an investment advice: The information provided on this website is intended for general information purposes only and does not constitute investment advice, financial advice, trading advice, or any other sort of advice. You should conduct your due diligence and, if necessary, consult a qualified independent financial advisor before making any investment decisions.

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Fernando

Fernando created Your Green Wealth to help investors find sustainable investing options. When not writing for Your Green Wealth, he is a business developer for renewable energy projects.

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