Green bonds are entering the mainstream, says NN IP
Market data confirms that the appeal of green bonds is increasing for a broader range of investors, according to NN Investment Partners (NN IP).
Having analysed index-level performance for the last four years, NN IP is convinced that green bond markets deserve to be assessed in a broader bond-market context. The returns and volatility, especially of corporate green bonds, make them a viable replacement for regular bonds in a credit portfolio.
Investors are increasingly allocating to green bonds in their portfolios. Their aim is often to make it clear and transparent to their stakeholders, for example, pension participants, that they are greenifying their investments. But NN IP believes that a broader range of investors could consider replacing parts of their bond portfolio with a green bond allocation, on the basis of their appealing risk-return profile.
NN IP analysed how green bond indices performed compared to regular indices for euro green bonds and for euro corporate green bonds. Only the last four years were included in the analysis as the green bond market was too underdeveloped before 2016 to make a comparison.
NN IP’s analysis shows how the Bloomberg Barclays MSCI Euro Green Bond Index has performed compared to an index of regular euro-denominated corporate and sovereign bonds (Bloomberg Barclays MSCI Euro Aggregate Index). In 2019 green bonds generated returns of 7.4 per cent compared to 6.0 per cent for regular bonds. Euro green bonds outperformed for three of the four years, by an average of 0.70 per cent per year. The annual volatility of the green bond index was higher for three of these years. This means that the higher returns were largely the result of higher risk.
The duration of the Bloomberg Barclays MSCI Euro Green Bond Index increased significantly in early 2017. At that time, the inclusion of the Republic of France’s first green government bond in the index had a big impact. This was a large issue (EUR7 billion) and the bonds had a 22-year lifetime, hence their effect on the index’s duration. This higher duration means that green bonds are more sensitive to interest-rate changes. And as interest rates continued to fall last year, the Bloomberg Barclays MSCI Euro Green Bond Index outperformed the Bloomberg Barclays Euro Aggregate Index over 2019.
Although the green bond market as a whole has grown significantly in recent years, the corporate segment has experienced particularly strong growth. This growth is also reflected in the breadth of the market, where an increasing number of industry segments are now represented. By comparing the Bloomberg Barclays MSCI Euro Green Bond Index: Corporate to the Bloomberg Barclays MSCI Euro Aggregate Corporate Index, the same performance and volatility comparisons can be made.
In 2019, corporate green bonds booked returns of 6.4 per cent compared to 6.2 per cent for regular corporate bonds and outperformed in three of the four years (2016, 2018, 2019). The annual volatility was also higher for all four years, but in the case of corporate bonds this gap has become smaller each year.
Given the strong divergence in annual volatility, NN IP also compared the daily volatility of these two corporate bond indices over the past four years (figure). The blue line indicates that the difference is trending consistently downward, meaning that, in terms of volatility, the green and non-green indices are moving towards each other. NN IP believes the reason for this convergence is the growth (shown on the right axis) and increased diversification of the corporate green bond market. The duration of the two indices is now almost equal.
Bram Bos, Lead Portfolio Manager Green Bonds, NN Investment Partners, says: “The results of this analysis strengthen our belief that investing in green bonds is an easy way to invest in fixed income more sustainably without having to compromise on performance. Over the past four years, green bond indices have in general performed better than traditional indices. Green bonds are typically issued by innovative, forward-looking issuers, whose activities are adapting to the urgency of climate change. As a result, these companies are less exposed to climate and ESG risks and are more transparent in their activities. The consistent outperformance of green bond indices versus regular bond indices underscores this and also makes a compelling argument for green bonds in a broader context.”
While in the case of the broader index that includes corporate and sovereign bonds, volatility was stable or rising, the situation is different for corporate green bonds. The results here show that the volatility of the corporate green bond index has been consistently moving closer to that of the traditional bond index. This shrinking volatility differential means that the barriers to replacing a portfolio of traditional corporate bonds with a portfolio of corporate green bonds have also diminished. The arguments are tipping in favour of corporate green bonds – not just as a way to create impact but also from a purely financial and risk-return perspective.
Bos adds: “This analysis has been carried out at index level and demonstrates that green bond indices are becoming a real alternative to regular bond indices. However, an actively managed green bond portfolio can offer additional benefits.”
The NN IP green bond strategy applies a stringent selection process to avoid light green bonds. This ensures that bonds are selected that finance projects that make a measurable positive contribution and that they are issued by companies that are truly committed to tackling core sustainability issues. As a result, about 15 per cent of the total outstanding bonds with a green bond label worldwide are rejected, leaving NN IP with a dark green bond universe.
Bos continues: “Once we have defined our universe, we can be selective and take a high-conviction view on individual investment candidates from a fundamental perspective. This allows us to construct more diversified, less concentrated portfolios and to target those bonds with the best risk-return profiles.”