Incorporating green bonds into an asset allocation

Green bonds: Compelling investment opportunity with environmental impact

Public fixed income markets can offer a compelling opportunity to drive positive outcomes in our communities and around the world. With state and local governments, international agencies and private corporations driving momentum towards a low-carbon economy, there has been a significant increase in both issuance and investor demand for “green bonds.” Green bonds provide investment opportunities that offer the potential to achieve a “double bottom line” of competitive financial returns, along with direct and measurable environmental benefits.  There are two types of green bonds:

• Labeled—Issues that meet specific industry conventions and/or receive third-party certifications
• Unlabeled—Proceeds used for climate-aligned projects and initiatives but are issued without formal certifications

Green bond growth & diversification

With its first issuance in 2007, the green bond market was concentrated by issuer type and use of proceeds. However, issuance and diversification has since grown exponentially with the labeled green bond valued at $812.7 billion while, the unlabeled green bond universe was last estimated over $1 trillion and growing.

 

 

This expansive universe provides a unique opportunity that can meet investors’ financial and environmental objectives of competitive total returns, outperformance potential and demonstrable climate-aligned outcomes. As the third largest investor in labeled green bonds globally – and largest in U.S. denominated issues¹, we believe these bonds can be a key component within an investor’s fixed-income allocation.

 

Potential to increase alpha with green bonds

It is a common misperception that investing in green bonds requires sacrificing investment returns. We believe that competitive performance and investing in green bonds are not mutually exclusive. These bonds should be subject to the same fundamental credit analysis and portfolio construction considerations as any other fixed income securities evaluating such factors as issuer quality, any related purchase power agreements and the credit quality of loan pools. While green bonds offer the potential for economic and environmental impact, they must also represent attractive relative value and appropriate levels of risk. In addition, we believe that securities, like green bonds, may also have the ability to potentially drive alpha and reduce risk, which may lead to a higher credit rating and lower cost of capital. For example, companies that make strides in water efficiency, may be better positioned to reduce production, operational and investment costs, while minimizing reputational damage. And companies that proactively manage their exposure to climate change risks may demonstrate stronger governance, and serve investor interests by mitigating costs that may address wide-ranging climate impacts.

Our impact approach: Direct and Measurable

It may be more difficult to assess the impact of these potential investments. While there are voluntary industry guidelines such as the Green Bond Principles and Social Bond Principles, we have developed a proprietary framework to help ensure that these investments are “direct and measurable

• Direct: This refers to the explicitly stated use of the bond’s proceeds. The capital raised must fund specific projects or initiatives that deliver a clearly defined environmental or social benefit, including pure-play issuers. Typically, general purpose debt does not meet this standard, whether it is issued by a corporation, government or municipality.
• Measurable: At least annually, an issuer must be able and willing to disclose key performance indicators (KPIs) through impact reporting for the designed project or initiative. Such disclosure enables us to assess both the financial and impact efficacy of the capital expenditure, informing our ongoing evaluation of the investment’s potential risk and providing transparency to our clients about specific impact outcomes.

Learn more about how our approach is reflected in the TIAA-CREF Core Impact Bond Fund and TIAA-CREF Green Bond Fund.

Incorporating into a portfolio

Green bonds can appeal to investors interested in a diversified fixed-income portfolio and to investors seeking to align their portfolios with specific impact goals. However, it may be more challenging for investors to research, purchase and hold individual green bonds versus investment managers with dedicated resources and their collective buying power. For the individual investor, buying or selling individual green bonds can be more expensive given that the market generally rewards larger transactions with better pricing. As a result, for most investors, the approach is typically one of Environmental, Social and Governance (ESG)-themed mutual funds, separately-managed accounts or ETFs. Given the rapidly increasing demand for responsible investments over the last few years, the fund industry has many competing options for investors to consider.

Ultimately, incorporating green bonds into an investor’s portfolio can be as simple as replacing a current fixed income strategy with an ESG or responsible investing strategy. By viewing these investments through the same lens as your other bond investments, you can look at conventional total return and risk-adjusted performance metrics relative to widely used bond market benchmarks and traditional peer groups. While providing compelling risk and return attributes, investors also benefit from making a positive environmental impact for municipalities, companies, investors and the world. With that in mind, the question becomes: why wouldn’t investors invest in green bonds?