Behind the Green Bond Boom

Companies, municipalities and countries are getting serious about building a low-carbon future, and they're increasingly using green bonds to finance climate-friendly projects. Green bond issuance doubled between 2015 and 2016 to $81 billion, and that number is on track to double again by the end of 2017.

This is likely just the beginning of what promises to be a burgeoning asset class, as governments and other entities will need to invest an estimated $90 trillion in infrastructure over the next 15 years to achieve goals outlined by the Global Commission on Economy and Climate. “Green bonds will be a key tool for getting there," says Jessica Alsford, Head of Morgan Stanley's Global Sustainability Research team.

While issuers are steadily adding to the supply of green bonds, the growth of ESG (environmental, social and governance) investing is driving demand in lock step. “Despite the exponential growth in volume, green bonds have still performed in an orderly way, roughly in line with the broad market," says Morgan Stanley cross-asset strategist Serena Tang. “This suggests that this isn't just a passing fad but a market that's sustainable in every sense of the word."

In a recent report, Morgan Stanley Research looks at what constitutes a green bond, how the category has performed thus far, and why investors should take a more nuanced approach to valuing these instruments. “For investors, the main takeaway is that green bonds perform roughly in line with the broad market," Tang adds.

The term green bonds loosely refers to debt securities whose proceeds are used to fund environmental or climate-friendly projects, such as renewable energy, green buildings, clean transportation, or sustainable water or wastewater. As investor interest in sustainable investing continues to grow, corporations are increasingly looking to green bonds to attract a diversified investor base and put a spotlight on their sustainable projects.

While many green bonds are self-labeled, the Climate Bonds Initiative and Green Bond Principles outline guidelines, including that most of a green bond's proceeds be used for green projects. In China, which accounted for 39% of total issuance in 2016, the definition is more liberal; for example, issuers can use up to half of the proceeds to repay bank loans and invest in general working capital.

Green municipal bonds, meanwhile, are a small but fast-growing segment of the muni market, with U.S. state-level plans for green infrastructure still moving ahead, even in the wake of President Trump's withdrawal from the Paris Climate Accord. The market has yet to reach critical mass, but given the kinds of projects funded by state and local governments, “the market should be a natural issuer of green and social impact bonds," notes Victoria Irving, Equity Strategist for the Global Sustainability Research team.

While the asset class is more than a decade old, comparing green bond performance to the broader market requires looking beyond absolute performance.

For example, the Bloomberg Barclays Green Bond Index, which was launched in 2014, has lagged the broad-based Barclays Global Aggregate slightly over the last three years—but keep in mind that overall returns don't account for the boom in green bond issuance over that period. What's more, since late 2016, green bonds have outperformed their conventional counterparts, both in absolute terms and on a risk-adjusted basis.

While the green bonds universe has slightly lagged broad market moves…

…risk-adjusted returns stand close to their highest since market inception

To better understand green bond performance and valuations in the secondary market, Morgan Stanley analyzed 121 self-labeled U.S. and European bonds, focusing on corporate, and government or government-related benchmark-size securities (at least $500 million).

“For the most part, investors can buy green bonds at similar spread levels to conventional bonds after adjusting for sector, curve and currency," says Tang. “There are, however, instances where green bonds are trading cheaper, and where investors may find opportunities to swap traditional bonds for green bonds."

In U.S. markets, for instance, green cyclicals and technology bonds trade at a premium to their non-green peers, but utilities and materials trade wide to their conventional curve. In Europe, financials and government-related green bonds traded at a premium to regular counterparts; green bonds in the utility sector traded at a discount.

For green bonds issued in the U.S., maturity had little sway on relative valuations, but in Europe, green bonds with maturities of less than 10 years traded at a premium to the regular curve; longer-dated dated bonds traded at wider spreads, offering potential for investors to find undervalued securities.

The type of projects funded by green bonds should impact valuations, says Tang, but that doesn't appear to be the case, yet. “This is likely a function of a small universe and lack of granularity in project classification," she says, noting that there was little variation in value for certified green bonds or for issuers who offered more transparency.

As the market continues to evolve, so too should the tools and valuation methods. “We believe that measuring the environmental impact will become more complex and enable greater comparison between green bonds," says Irving.

Likewise, the muni market still lacks consistent standards and labeling, but this shouldn't be a deterrent for investors. If anything, the report states that munis may offer a compelling opportunity to achieve social impact while still earning a respectable market yield.

For more Morgan Stanley Research on the outlook for green bonds and ESG investing, ask your Morgan Stanley representative or Financial Advisor for the full report, “Why We Think Green Bonds Will Continue to Grow: A Primer," (September 21, 2017). Plus, more Ideas.