Five reasons to make a dedicated allocation to green bonds

Ridhima Sharma
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Five reasons to make a dedicated allocation to green bonds

Green bonds are emerging rapidly as a new category within fixed income. The market has been growing impressively over the past few years and keeps on broadening in terms of countries, currencies, sectors and seniority/ranking. We think that the green bond market has reached a point at which the barrier for investors to make an allocation to green bonds is relatively low. There are different ways of implementing green bonds in your investment portfolio. Some investors include green bonds in their existing portfolios, for example buying some green bonds in a normal or regular credit portfolio. Recently, more investors are allocating a separate part of their assets to a portfolio which exclusively holds and buys green bonds.

Here are five reasons why a dedicated allocation to green bonds adds more value than buying green bonds in a regular portfolio:

1: Emphasizing the responsible investing strategy
An allocation to a dedicated green bond portfolio is a clear and visible statement that the investor is paying attention to climate change, impact investing and responsible investing. Internal and external stakeholders (for example a pension fund sponsor or insurance client) take note of a fixed allocation to green bonds, which aligns with a broader responsible investing strategy. We have seen recently that a broader group of investors prefers a dedicated green bond allocation also because the green bond market becomes more diversified and mature.

2: A consistent and visible exposure to green bonds
Green bonds currently are being issued in a broad range of fixed income sub-asset classes: sovereign, credits, EMD and ABS. It is therefore very likely that every asset manager who manages a regular portfolio buys some green bonds. We think that highlighting green bond holdings in regular portfolios often gives a wrong impression. Less ESG-compliant investors can in fact ‘abuse’ their green bond holdings by using them to pretend they have strong ESG policies in place, when in fact the green bond exposure is more of a coincidence than a conscious choice. Another risk is that if one has for example an exposure of 5% to green bonds at a certain moment in time, this could be ‘window-dressing’ as the percentage through the remainder of the year or past year may be much lower.

3: A clear definition of green: avoiding ‘green-washing’
Current portfolios often include green labeled bonds, and as noted, this may be more of a coincidence then a conscious allocation. For these portfolios the manager often does not look at the type of projects which are financed and what green structure is bought into. The risk of green-washing is very high. For example, would you buy a green bond from an issuer who also finances (nuclear) weapon suppliers or trade arms in its regular business? If so, what is good practice and what is below market standards? The reputational risk is high if one takes the green label for granted.

4: More engagement with green bond issuers on ESG topics
One of the clear benefits of allocating separately to green bonds is the high level of potential engagement. Such allocations are not only more visible to internal and external stakeholders. They are also visible to green bond issuers, who prefer to engage with investors who have clear defined green bond mandates and portfolios. Issuers prefer to allocate more to dedicated green bond portfolios as this is a reliable and diversifying source of funding with a long time horizon. In our experience, dialogue with the issuers of the holdings in our green bond strategies adds a lot of value. We personally know all green bond issuers in our portfolios. This gives us not only the opportunity to discuss the green projects they finance, but also to discuss broader ESG topics. Our level of engagement is much higher than it would be with a regular portfolio. We see ourselves more as a partner of the issuer than an anonymous investor in the issuer’s bonds.

5: Impact reporting
The green bond label is voluntary and everybody can label a bond ‘green’. That is why we spend a lot of time analyzing the green bonds before they are issued in the market. The process does not stop there. After issuance it is an ongoing screening process to make sure that the issuer spends the proceeds according to their commitments. We also measure the impact of our Green Bond strategy. How much CO2 emissions are reduced by your investment in our Green Bond strategy? What type of projects are being financed, and in which regions? The impact report is an important benefit of investing in a dedicated green bond strategy. Creating an impact report is a very labor-intensive process and as a result it is mostly not provided for in regular portfolios. Therefore it is difficult to prove that these regular portfolios contribute positively to the environment.

Both retail and institutional investors continue looking for ways to make a positive contribution to the environment. Investing in green bonds creates this type of opportunity given that green bonds investing offers these type of investors the opportunity to ‘green’ their investment grade fixed income exposure and at no additional cost. From this perspective, green bonds are an obvious choice for fixed-income investors.

Bram Bos, lead portfolio manager Green Bonds at NN Investment Partners

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