Supply in the green bond market is struggling to keep up with demand as investor interest continues to grow. As a result, investors could end up paying a premium simply to buy in.
Climate change and how businesses deal with it are becoming an increasingly important issue for investors as they demand more transparency to evaluate investment risks. Total issuance of green bonds — debt that finances environmentally friendly projects — is expected to reach $250 billion in 2018, from a virtual standing start in 2012, according to data from the nonprofit Climate Bonds Initiative, or CBI.
Despite the rapid expansion of the market, however, demand for green debt continues to outstrip supply as institutional investors increasingly apply environmental, social and governance ESG criteria to their investment policies. Partly as a result of this, the average final pricing of U.S. dollar- and euro-denominated green bonds is around 2 basis points tighter, relative to initial pricing thoughts, than that of "vanilla" bonds, according to the CBI.
That figure is roughly in line with general market chatter, according to Michael Wilkins, head of sustainable finance at S&P Global Ratings.
"It does vary but typically people say around 3 basis points is what you see as a pricing advantage," Wilkins said. "It does vary from bond to bond and some bonds have achieved a higher advantage. The biggest reason is the lack of supply versus demand."
'Greenium' could offset added green bond costs
New bond issuances typically price with a yield slightly higher than that on equivalent debt from the same issuer already trading in the secondary market, in what is known as a new issue premium. But of a dozen third-quarter 2017 green bond issuances studied by Climate Bonds Initiative, two were priced with a "greenium," indicating that they yielded less than existing debt, while four others priced with no new issue premium.
The yield reflects the coupon, or interest rate, paid on a bond adjusted for the percentage of face value paid by the acquiring investor. The yield falls as the price rises.
All other things equal, green bonds are slightly more expensive for an issuer, because it must monitor the debt's compliance with generally accepted principles for such securities. Being able to place the notes with a "greenium" could help offset that, said Robert Scharfe, CEO of the Luxembourg Stock Exchange, which operates a green bond exchange.
On issuance, green bonds "are swallowed up immediately," meaning that there is ample demand in the secondary market, Scharfe added.
"The secondary market is where investors are getting their value out of green bonds," Wilkins said, "with the spread tightening even more than in the primary, sometimes as much as 20 to 25 basis points ... versus non-green."
According to CBI data, green bonds are generally outperforming indices, with 79% tightening more than their corresponding index seven days after announcement date. That may help draw more "traditional" investors, i.e. those attracted for monetary, rather than environmental, reasons.
"If you invest in a green fund, the fund may pay slightly more to purchase an instrument. However, the fund also has the opportunity to potentially sell it also at a slight premium," said Tom Kinmonth, a fixed-income strategist at ABN AMRO.
In addition, NatWest Markets has found that green bonds can create a "halo effect" for an issuer, pushing down yields across their bond portfolio.
Premiums could set trend
Scharfe said future pricing will depend on how quickly investors shift their preferences. "This is normal evolution in a market which is nascent and just needs to find its solid base," he said.
The current price premiums could set a trend, though, with existing green bonds beginning to serve as a reference point for new bond pricing.
"If green bonds were trading tighter than vanilla bonds, we would reasonably expect to see a consistent greenium emerging," Climate Bonds Initiative said.
Pricing may also change as investors take into account the environmental benefits of a green bond issue, S&P Global Ratings' Wilkins said.
"The pricing of green bonds does not correlate with the environmental impact being provided by the green bond and that is something we think will change over time," he said. "You usually see a correlation between the credit spread and the credit rating so the higher the rating, the smaller the spread to reflect risk or lack of risk. At the moment that spread advantage is not correlated to the greenness of the bond."
S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.
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