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What are green bonds and how do they impact the world?

Here's a way to directly fund climate solutions by funding the projects that will transition the world to net-zero

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The green bond market is the latest environmental, social and governance (ESG) investment tool that is rapidly growing, especially in the corporate sector.

But it goes beyond simply doing the right thing – the sector remains attractive from a risk-reward perspective, too.

Although the market is still in relative infancy, it is set to grow over the next 3 decades as the transition to net-zero intensifies.

Green bonds explained

Green bonds are relatively similar to any other form of bond except they have a green, or "environmental", feature.

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.

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.

And while this makes it a sizable 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.

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 them directly

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

Pros

  • Environmentally friendly
  • Incredibly large and growing market
  • Direct access to helping fight climate change
  • Allows you to diversify your assets through green bonds

Cons

  • 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.

Bottom line

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.

But for those who are looking to do the right thing and want to grow their money in a sustainable fashion, a green bond can serve this purpose.

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