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  • ETF Insights

    Incorporating Green Into a Portfolio

    William Sokol ,Senior ETF Product Manager
    January 31, 2019
     

    With green bond issuance reaching new highs and once again surpassing $160B in 2018,1 we sat down with Senior ETF Product Manager William Sokol to discuss what makes a bond “green” and how green bonds can fit within an investor’s portfolio.

    What are green bonds, and what is the value proposition of green bonds?

    Green bonds are like any other bond, except that they only finance environmentally friendly projects, like renewable energy, energy efficiency, mass transit, and others. They are defined by the projects they finance rather than the broader activities of the issuer, and any type of issuer can issue a green bond regardless of the issuer type or sector. They can allow investors to integrate sustainability into their portfolios without sacrificing return. In the vast majority of cases, green bond investors are not assuming the risk of the projects that are being financed, which I think is probably the most powerful value proposition of green bonds. They are backed by the full balance sheet of the issuer, rather than the cash flow of the underlying projects, so the risk/return profile is the same as a conventional bond, all else equal. For example, a green bond issued by Apple should provide a similar yield and return as a non-green Apple bond, after adjusting for factors like differences in maturity or liquidity.

    Another attractive feature of green bonds relates to environmental impact. Green bonds are defined by what they finance, rather than the issuer, and investors can get data on specific projects funded by an individual bond. That helps investors quantify the impact their investment is making, with metrics such as carbon emissions reduced and water saved. There is certainly more progress to be made around measuring and reporting environmental impact, but most issuers are providing information. This transparency is another very powerful value proposition of green bond investing, especially for impact-oriented investors.

    How do bonds get classified as “green”, and what is the process for determining what VanEck Vectors® Green Bond ETF (GRNB®) invests in?

    Projects like solar and wind are generally pretty unambiguously green and environmentally friendly, but it can be less clear when we talk about things like certain hydroelectric projects or clean coal. When we were developing VanEck Vectors® Green Bond ETF (GRNB®), we knew that having an objective, science-based framework would be crucial, to let investors know that the bonds GRNB invests in are truly green. And we believe that you need a thorough, independent review of each bond and cannot rely on the self-labelling by green bond issuers.

    To do that, we partnered with a non-governmental organization called the Climate Bonds Initiative (CBI). The CBI is the leading voice helping to mobilize the debt markets to fund climate solutions, and its framework is recognized globally by a wide range of market participants.

    The CBI reviews all green bonds issued in the global market and assesses available information to establish whether the projects financed are aligned with its green bond project taxonomy. The overarching principle of this taxonomy is that the projects included must align with the objective of the Paris Agreement, which is to limit global warming to well within 2 degrees Celsius above pre-industrial levels through a rapid and dramatic reduction of greenhouse gas emissions. This taxonomy is reviewed and updated periodically to ensure that it reflects current technologies as well as the latest climate research.

    If there is sufficient information available and the CBI determines that the projects are aligned with its taxonomy, the bond is eligible for GRNB’s index. If the projects are not aligned or there isn’t enough information available to make that determination, it’s not eligible. The CBI also reviews ongoing reporting after a bond is issued to monitor for any change or new information that would affect a bond’s eligibility.

    Beyond this green criteria, GRNB’s index provider, S&P Dow Jones Indices, applies additional screens to remove illiquid bonds, and applies issuer caps to improve diversification. The result is a broad representation of the tradeable green bond market, and investors can have confidence that the bonds are truly green thanks to the independent review conducted by the CBI.

    How are investors using GRNB in their portfolios?

    First, let’s forget about the green aspect and just look at the exposure: it’s multi-sector, diversified, and high quality. It’s very much in line with an aggregate fixed income type exposure, which means it can fit neatly into a core bond portfolio. And that’s where we see most investors using GRNB – as a way to invest sustainably within the core. Yield and duration are in line with the agg, so investors can shift part of their core bond allocation to green bonds with very little impact from that perspective, while also getting sector diversification.

    Another way we see investors using green bonds within a fixed income portfolio is as a risk mitigator. Climate risk is complex and not well understood, and it tends to not get priced in by the market like interest rate or credit risk. Examples of climate risk would be an energy company whose assets are primarily made up of underground oil reserves, or a municipality whose infrastructure assets are vulnerable to rising sea levels. Currently the market isn’t really distinguishing between these issuers, who are exposed to climate change, and those who are not or less so. When the market begins to price in climate risk, we would expect these issuers to underperform versus issuers who have taken steps to mitigate their climate risk.

    A green bond strategy may provide investors exposure to issuers who are proactively addressing climate risk. And because you don’t currently give up yield, you can think of green bonds as a cheap or free hedge against climate risk in a portfolio.

    What else should investors consider when constructing a more sustainable investment portfolio?

    There’s clearly a lot of interest in environmental, social, and governance (ESG) investing as awareness grows, and the strong interest from millennials and high net worth investors is well documented. But one of the biggest barriers to wider adoption is confusion about the terms and the lack of standards and consistency among ESG investing strategies.

    One thing I would emphasize is how green bonds can overcome this confusion. Remember that the defining characteristic of green bonds is the projects being financed, rather than the activities of the issuer, which is what an ESG score represents. ESG scores can vary widely between different ESG research providers because of the subjectivity involved, typically reflecting the opinion of an index provider or research firm.

    We believe that green bonds can be a solution to this problem. Because they’re defined by what they finance, there is less subjectivity involved versus an assessment of the issuer’s broader business activity. They are also a more direct way of investing sustainably because they allow investors to target specific projects that have a positive environmental impact. Moreover, I would argue that they are more forward looking, because they finance projects that will have a future environmental benefit, and are not selected based on an ESG score, which is often based on backwards looking data.

    For these reasons, we think green bonds provide a straightforward approach to sustainable investing, allowing investors to make a positive impact with their investment, without having to compromise on return objectives.