By Hamlin Lovell, NordicInvestor

The ‘E’ in ESG

The genesis of the green bonds market came from Sweden, where a group of pension funds, working with the World Bank, conceived the concept ten years ago. For the first five years, issuance of green bonds was measured in single digit billions, but has recently accelerated to USD 80 billion in 2016, USD 155 billion in 2017, and a forecast USD 250 billion in 2018, according to the Climate Bonds Initiative (CBI).

The term “green bonds” has a relatively clear meaning. “The term is specific. Green bonds finance a project with an environmental aim. For example, transport companies trying to move to electric power rather than fossil fuels, or various modernisation projects” explains Lyxor ETF’s Head of ETF Strategy for Northern Europe, Adam Laird. “Strictly speaking, the issuer itself doesn’t need to have an environmental aim, but the bond must have money ring-fenced for an environmental purpose” he clarifies. Issuers can be governments, supra-national organisations, and companies.

Lyxor has an open architecture approach to index providers, working with the largest ones such as MSCI and FTSE, in addition to niche and specialist players. “For green bonds, we have decided to use the Climate Bond Initiative classification. They and index provider Solactive carry out ongoing monitoring of companies to ensure that the money is used for the original purpose” he explains.

“The CBI criteria are closely in line with the plans and consultation work at EU level to categorise green bonds using formal criteria” he adds. Amid a proliferation of labels for various ESG strategies, the EU plans to create a consistent taxonomy for naming all sorts of ESG approaches.

Green bonds are primarily focused on the ‘E’ or Environmental within ESG. Though this will also, indirectly, have some positive social impact, other bonds classified as “social bonds” do not come under the green bonds umbrella.

Yet environmental investing is itself a broad church. At one end of the spectrum, investors might simply exclude companies involved in producing large amounts of coal, carbon emissions, methane emissions and so on, an approach that can be dubbed “light green”. At the other end of the continuum, “dark green” investors actively seek out those companies that could make a positive impact on the environment, through renewable energy such as water, wind or solar power. “Green bonds are very much in the dark green camp, and can be seen as a form of impact investing. They are about trying to solve carbon, pollution and environmental issues” explains Laird.

CBI and Solactive partnership

As well as finding bonds that will help to improve the environment, Solactive pays attention to liquidity to ensure that the index can scale up its assets – and also to minimise transactions costs associated with rebalancing in response to inflows or outflows. Therefore, issue size and liquidity criteria will rule out some of the smaller green bond issues. All of the bonds in the Solactive index have satisfied the liquidity criteria for a UCITS and an ETF.

The rationale for investing in green bonds is mainly ethical, as they are not expected to offer higher financial returns. Green bond yields are neither higher nor lower than those on comparable non-green bonds, according to Laird. As green bonds become a more mainstream asset class, they are performing closely with conventional bonds.

The methodology Lyxor uses to track the Solactive Green Bond EUR USD IG Index is sampling, rather than full replication, but in practice it has been pretty close to full replication. “We will not always buy every single issue, but have tracked the index quite precisely so far” says Laird. In the year to 28 November, the unhedged EUR denominated ETF [CLIM FP] has grown 1.01% (EUR) compared to the index of 1.20%. The difference of 0.19% is very close to the Total Expense Ratio (TER) of 0.25% (and this does not include any revenues from security lending, which Lyxor ETFs refrain from). The unhedged EUR share class has benefited from USD appreciation versus the Euro. Remember of course, past performance is no guide to future returns.

In contrast, the EUR hedged version [KLMH GY] had returns of minus 0.97% in the year to 28 November, partly because it did not profit from the rise in the greenback, and also due to the hedging costs caused by the interest rate difference between USD and EUR. The customary disclaimer that returns are variable and not guaranteed bears repeating. There is also an unhedged GBP share class [CLIM LN].

The growing ETF market

ETFs – like green bonds – are clearly a mainstream investment vehicle, with assets of over $4 trillion globally. In March 2018, Laird became the first Chairman of the UK Investment Association’s (IA) ETF committee, and in November 2018, the IA announced that ETFs would be included in its categories of investment strategies, which are widely used by investors. This means that investors can easily compare open ended mutual funds, which trade once a day, and ETFs, which can be traded intraday, side by side.

Lyxor has not made any announcements in relation to other green bond ETFs, but as the asset class grows, it is interesting to speculate about possible variations on the theme.

The yield on Lyxor’s green bond ETF is around 1.7%, which is typical for a blend of EUR and USD denominated investment grade debt with duration of seven to eight years. Lyxor runs other ETFs investing in high yield corporate debt, which have higher yields, but for the time being Laird is not sure if the market for high yield green bonds is big enough to accommodate an ETF.

What may be more relevant is that high yield bonds would not fit the typical risk profile that investors seek from a green bond allocation. “For many investors, green bonds are providing an element of stability in a higher yielding ethical equity portfolio. Investors are looking for lower volatility and are willing to accept a lower yield” he says.

Credit in general and investment grade credit in particular have had a challenging year in 2018 – the worst year since 2008 on some measures – with headwinds coming both from interest rate sensitivity and credit spread widening. Green bonds have been no exception to this rule, and their yield has been partly offset by negative performance arising from duration and spread sensitivities.

The interest rate duration on Lyxor’s ETF is around 7.5 years, which could make it vulnerable to further rate rises. Lyxor runs other credit ETFs that have minimal duration as they own floating rate assets. The firm could contemplate at some stage creating a floating rate green bond ETF, Laird envisages.


* Source for ETF data, including portfolio and charges: Lyxor ETF, Bloomberg correct November 2018