Green bonds are rapidly growing as investors look to help the transition to net zero.
But it goes beyond simply doing the right thing – the sector remains attractive from a risk-reward perspective, too.
Like any traditional bond, they behave as a loan between the issuer – which can be governments or corporations – and investors. In the case of green bonds, this loan is used to fund green projects ranging from renewable energies to transportation, agriculture production and sustainable source uses.
Again, like traditional bonds, you'll agree to give a certain amount of money to the issuer of the bond for a set timeframe in exchange for periodic investment payments.
What are green bonds?
A green bond is a type of fixed-income that has been issued to raise money for climate or environmental projects.
These bonds can be provided by either a government or private corporations.
The green bond market is still in its infancy but is rapidly growing.
The history of green bonds dates back to 2007. Fast forward to 2022 and according to the Responsible Investing Association of Australia (RIAA), "impact investing" locally is worth $30 billion. They say that $24.6 billion is channelled into "green, climate or social impact" bonds.
Why invest in green bonds?
Green bonds offer an attractive alternative to regular bonds, with most investing for 3 main reasons:
1. Align your values with your money
Much like all environmental, social and governance (ESG) investing, the sector is built on the back of investors wanting more than just returns from their capital.
2. Diversify from traditional bonds
Just like all sectors in investing, diversification is important.
Green bonds allow you to diversify into different forms of government or corporate debt, reducing your risk.
3. Tax benefits
In some cases, pending tax laws where the bond is issued, green bonds have the added perk of giving you a tax incentive.
This is because governments are actively trying to reduce their emissions, with debt instruments like green bonds helping this transition towards cleaner energy.
Size of the market and opportunity
The green bond market has been a relatively slow starter for the first decade following its inception in 2007. But, over the last 5 years it has been quick to make up for lost time.
The World Economic Forum is now predicting that by 2023, there will be over US$1 trillion invested in green bonds.
Unfortunately, that is not nearly enough to combat climate change. According to research by McKinsey, net-zero will cost around US$275 trillion by 2050 or require an investment of US$9.2 trillion per year on average, an annual increase of US$3.5 trillion. While not every dollar will be issued in bonds, the sheer size still remains huge.
And while this makes it a sizeable investment opportunity, as McKinsey states, this additional investment is about half of global corporate profits, one-quarter of total tax reviews or around 7% of total household spending.
Do green bonds fight climate change?
Green bonds can play a critical role in fighting climate change as they help to fund the transition to net-zero or a low carbon environment.
Green bonds after all are used to fund projects that will directly impact the climate.
- Renewable energy projects, such as solar and wind farms
- Clean rail transportation
- Low carbon buildings
- Energy efficiency upgrades
- Environmentally sustainable housing
- Electric vehicles
As you can see, all of these projects are directly funding issues we need to solve if we are to fight climate change, meaning investing in green bonds will help.
How to get involved
There are 3 ways you can buy green bonds as a retail investor:
- Exchange-traded funds (ETFs) that own green bonds
- Superannuation funds
- Buying through a wholesaler
Buying green bonds directly is a little challenging.
Bonds are traditionally targeted at financial institutions and superannuation funds due to the pool of resources they have.
As such, in most cases you'll need to buy a green bond through an intermediary such as financial institutions, an ETF or through your superannuation.
Outlook for green bonds
The good news for those in the green bond space is that the sector is continuing to gain investor interest.
Governments and corporations alike are looking for ways to reduce their carbon footprint. And lots of these expenses require the issuing of debt.
As such, the green bond market is tipped to continue its growth.
Pros and cons of green bonds
- Environmentally friendly
- Incredibly large and growing market
- Direct access to helping fight climate change
- Allows you to diversify your assets through green bonds
- Can be hard to access
- All bond return rates, including green bonds, are lower than other financial assets
- Not easy to identify impact
- Lack of liquidity in the market
Other sustainable bonds
Like everything in finance, the market has evolved from the simple green bond.
Investors now have the choice of:
Blue bonds – Blue bonds are a subsection of green bonds that are specifically aimed at ocean conservation. These include managing waste, promoting marine biodiversity and ecologically friendly developments. But blue bonds are still rare – there are only 6 blue bonds issued by late 2021.
Transition bonds – As the name suggests, these bonds are to help businesses transition towards a more renewable future. Aiming at traditional brown and olive industries (think mining, commodities, etc.), these bonds help move these industries towards a greener future. And while ESG investors might not love helping miners, it can have a big impact on climate action.
Sustainability linked bonds – Sustainability linked bonds (SLBs) differ as they have no restrictions on how the money is spent. Instead, it is based on the business itself. Should a company meet sustainable targets in any environmental, social or governance metrics, they are eligible for funding.
Social bonds – These tackle a very different but equally as important part of ESG, being social. As such, these bonds are used to finance goods and services that have a positive outcome in society, for example, education, housing and improving food security.
Green bonds vs sustainability linked bonds
The main difference between the two bond types is that one is more restrictive than the other.
A green bond will help the transition to net-zero and fund a number of other environmental processes, but it can't go beyond this mandate.
On the other hand a sustainability linked bond (SLB) is aimed at all of the UN's 17 sustainable development goals. These range from clean water for all right through to environmental goals. As such, an SLB is a broader range bond that can help fix more issues in the world then green bonds.
However, the two don't work exclusively of each other. Sustainability linked bonds are meant to complement green bonds and should enable more issuers to gain access to financial markets for differing projects that traditional green ESG investors would want to be financed.
As the trend towards ESG continues, there is little doubt that green bonds are growing and will continue to do so.
They are still an emerging asset class, placing limitations in terms of liquidity and options for investors.
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