Building a Diversified Green Bonds Portfolio

By Hamlin Lovell, NordicInvestor

Following our recent roundtable (read or watch it here), we interviewed Douglas Farquhar – Client Portfolio Manager, Green Bonds, NN Investment Partners, to discuss ways in which investors can, and cannot, diversify a green bond portfolio, given the current investment universe.

Record issuance of EUR 40 billion in September 2020 has taken the total for 2020 to over EUR 170 billion and increased the green bond market size to over EUR 650 billion. There are 2,650 issues, but fewer issuers since some entities are repeat issuers. It is possible to build a diversified investment grade portfolio of either sovereign or corporate debt, or a mix of both, but more diverse issuance is probably needed before this becomes feasible on the liquid corporate high yield side.

“Green bonds are a very liquid and diverse market, made up of sovereigns and corporates with credit quality, yield and duration that are in aggregate very similar to conventional bonds on the investment grade side”, says Douglas Farquhar, – Client Portfolio Manager, Green Bonds, NN Investment Partners.

Industries and sectors

For both green and conventional bonds, most investment grade issuance still comes from sovereigns and quasi-sovereigns, including local governments, development banks (such as the World Bank, European Investment Bank, European Bank for Reconstruction and Development and African Development Bank), supranational government organisations such as the EU, and state-owned enterprises, as well as central governments.

There are more differences on the corporate side: “the industry mix and sector makeup is very different, with some sectors over-represented and others under-represented. Utilities are the largest sector at 40%, as they were big issuers in 2012-2016, when green bonds were mainly related to renewable energy.

Incidentally, utility green bonds are not always labelled as utilities and can be broken down into other more granular categories such as electricity or gas, as NN does in its investor reports. Some utility bonds are also described as “energy” based on their use of proceeds for renewable energy, although the term “energy” can also cover oil companies.

Railway companies such as Société du Grand Paris, French railways group SNCF, and New York’s Metropolitan Transport Authority are also a large group of issuers.

Meanwhile, “industrials and autos were very under-represented, bar Tesla and Toyota, though this is starting to change with new issues from Daimler and VW this year. Technology and communications remain under-represented though there are issues from Telefonica, Vodafone, Apple and Alphabet. FMCG (Fast Moving Consumer Goods) are still scarce”, he points out.

Countries

European issuers continue to make up over half of assets raised, though the US, Canada and China are becoming significant issuers of green bonds. “Euro-denominated funds benchmarked against a Euro-denominated index are still likely to be mainly invested in Euro issues, from European issuers, though we do have freedom to invest up to 30% in non-Euro issues”, says Farquhar. NN also has longer term ambitions to develop a global strategy as the universe and its research coverage expands.

Countries to some degree overlap with sectors, so a mandate restricted to certain countries or regions can also end up with (possibly unintended) sector biases.

A Biden Presidency might stimulate more issuance in the US, though there is already keen interest at the state-level with California and New York both keen to encourage issuance.

Types of Bonds

Investors can obtain additional diversification through green debt with different financial features. Green bonds are mainly fixed income, but they can have floating rate coupons that might increase if interest rates ever rise in future.

There are also somewhat innovative structures whereby the income can step up or down depending on the achievement of green targets.

There are as well green convertibles, preferreds, mandatories, and other types of hybrids, that can entail some equity exposure. For instance, Tesla issued a convertible green bond in 2013, and in September 2020, French utility, EDF, recently issued the largest ever green convertible bond, raising EUR 2.4 billion for an issue.

There are also green bonds structured as Islamic “Sukuks”, including one issued by Indonesia’s Government. These are not exactly comparable to traditional corporate debt because the credit risk of an Islamic bond is conceptually and practically different.

Schuldshein, covered bonds and mortgage backed securities are other categories that can also offer a different risk profile.

High Yield

The main area where green bonds are deficient is in the volume and variety of high yield debt, as of October 2020. Most green bonds are investment grade, and there may not be a sufficient universe of high yield issues to build a well-diversified portfolio that keeps issuer default risk at an acceptable level. This makes green bonds a challenging asset class for investors who need income: in a low yield environment, sovereign and corporate green bonds are yielding less than 1%, and generally within 2 or 3 basis points of comparable non-green bonds. Though “roll down” can also contribute to returns, expectations for returns are modest at present.

Some banks, such as Spain’s BBVA, and insurance companies, such as Italy’s Generali, have issued subordinated debt offering higher yields: as high as 6% at the time of issue for BBVA’s Tier 1 green bond. There are however differences of opinion over whether the use of proceeds from such issues should be earmarked for certain lending or projects in order for these to be classified as green bonds.

Going forward, companies’ targets for carbon neutrality and associated shifts in business models could increase high yield issuance. Transitioning from carbon intensive activities to renewables is by its nature riskier, since there are risks of some legacy capital becoming obsolescent “stranded assets” or at least seeing big write downs, and it may take some trial and error to work out how existing corporate assets can be redeployed into new activities. Investors should probably demand a higher yield to bear the risks of some companies’ carbon transition strategies.

Private and infrastructure

For investors with longer time horizons, some forms of private debt or infrastructure debt that are funding projects such as renewables could offer higher yields. They might be perceived as “green bonds”, and might at some stage be re-labelled as such. A strictly defined “green bonds” investment mandate might not be able to invest in them but a more broadly defined “sustainable bonds” mandate could do so.