Until March 2022, sustainable bond funds experienced a positive five-year period in terms of returns and low volatility compared to traditional bond products, but then the relationship reversed. That’s “because of their higher average duration, which made them suffer greatly in a period of rising interest rates,” Mara Dobrescu, head of fixed income analysis at Morningstar, explained on Thursday.
“Investors looking to invest in green, social and sustainable bond funds should be mindful of the biases these funds may introduce in their portfolio,” according to Dobrescu. “Indeed, our data has shown that most sustainable bond funds have a higher average duration than their traditional global bond peers, meaning that they will be more sensitive to variations in interest rates. This should benefit them when rates fall.”
What Are Green, Social and Sustainability-Linked Bonds?
USD 870 billion in new sustainable bonds were issued globally in 2023, pushing the outstanding amount at year-end towards the record threshold of USD 4.4 trillion, across over 43,000 individual bonds worldwide, according to data from the non-profit Climate Bonds Initiative.
As the chart below shows, green bonds continue to account for two-thirds of the market. But what exactly are they? They are issued to raise money for the sole purpose of financing new or existing projects or activities that have a positive impact on the environment. These projects can include renewable energy, energy efficiency, waste management, sustainable transport and other green initiatives.
However, there are other types of sustainable bonds: Social bonds, for example, are intended to finance new projects and refinance existing ones, with a positive social impact. The projects are most commonly aimed at supporting low-income, unemployed or otherwise vulnerable parts of the population.
Meanwhile, sustainability-linked bonds (SLB) have structural features, such as interest rates, that are linked to the achievement of sustainability goals. Unlike green bonds, they are not linked to the realisation of a single sustainability project. The proceeds from the bond issue can be used for general purposes, linked to an overall sustainability strategy with targets that can be measured year by year. These bonds are the most ‘generalist’ category within ESG fixed income in that they can include environmental targets, social targets or a combination of both.
Funds and ETFs Exposed to Sustainable Bonds
There are just under 300 bond funds and ETFs in Europe that are classified under Article 9 by the SFDR, the European Union’s regulation on sustainable finance that came into force in March 2021. These are those strategies that focus on a ‘clear sustainable objective’ and are informally called ‘dark green’ strategies.
In the first four months of the year, these funds recorded EUR 4.2 billion in net inflows, marking an organic growth of 5.4%, higher than the 3.3% growth of the total universe of Europe-domiciled fixed income funds. By the end of April, they reached EUR 75 billion in assets under management.
Morningstar ratings give a useful indication of how these strategies have performed in the past (Star Rating) and how Morningstar analysts think they might perform in the future (Medalist Rating) relative to their category peers.
Another characteristic of these funds is their greater exposure to the euro. An investor who decides to switch from an allocation in traditional global bonds to one exclusively in sustainable bonds would see his or her exposure to euro issues almost triple to 61%, at the expense of US dollar issues, which would fall to 26%.
The central role of Europe was confirmed again last year: It was the largest source of sustainable debt instruments with a volume of USD 405 billion, representing 46% of the 2023 total. Latin America and the Caribbean recorded a 49% year-on-year surge. In contrast, anti-ESG sentiment affected the US volume, with a 38% decline.
At the individual country level, however, the 2023 ranking has China in the lead with USD 83.5 billion of green bonds issued, followed by Germany at USD 67.5 billion and the US at USD 59.9 billion.
Green and sustainable bond funds tend to have higher allocations to corporate bonds, particularly in the financial sector, and quasi-sovereigns, at the expense of traditional government bonds. “This can cause them to struggle more than conventional bond products when credit markets stumble,” Morningstar’s Dobrescu warns.
Governments Issue Green Bonds to Finance Rail & Renewables
According to the GSS Bond Report analysis by MainStreet Partners, a global record in green sovereign bond issuance was reached in 2023, exceeding USD 160 billion. “Clean transportation is the sector most financed by government issuers, to date accounting for 43% of the cumulative volume issued since 2012 – more than three times as much as the category most financed by the remaining part of the market, renewable energy,” the study states.
Belgium’s 2018 green bond partly financed the railway system, while in France the proceeds were partly dedicated to tax exemptions for renewable energy and biodiversity projects. In Asia, on the other hand, in response to increasing levels of urbanisation, green bonds are often used to finance sustainable housing projects.
In a Hot Market, Due Diligence is Key
Driven by institutional investors, the green bond market should experience continued growth in the years to come. Investors need to pay attention to each issue’s quality and be wary of marketing promises.
Selectivity and transparency actually help to ensure that the most relevant and impactful green projects receive the necessary funding. The market remains in its infancy and plagued by greenwashing, so in-depth research on issuers is crucial for investors.
