As the impact of environmental, social and governance (ESG) factors on investments becomes better understood, investors are increasingly incorporating sustainability into their portfolios. Mounting evidence has found that ESG investing can contribute to better long-term investment outcomes, contrary to the outdated perception that it means sacrificing returns. For example, Morgan Stanley recently concluded that sustainable investment funds have provided comparable returns versus their categories with lower downside risk, and outperformed in periods of high market volatility. Perhaps that helps explain why flows into these strategies have exploded. Inflows into sustainable ETFs in the U.S, which were middling until recently, have grown over the past three years and exceeded $5 billion through July, far outpacing 2018’s full-year amount, which itself was a record for the space.
We believe that green bonds can provide an attractive way for investors to incorporate sustainability into their fixed income portfolios. Compared to strategies that select or weight constituents based on an overall assessment of an issuer’s broader activities, we believe green bonds offer a more objective approach. Further, they allow for greater impact because through green bonds, investors may allocate capital directly to projects with an environmental benefit. And because a green bond strategy is based on projects with a future benefit, rather than a backwards looking assessment of ESG indicators, we believe green bonds offer a more forward-looking approach.
Problem: Low Yields and Currency Risk
Unfortunately, the global nature of the green bond market has historically made it less attractive for U.S. dollar-based investors to incorporate these investments into their portfolios, even if the green aspect may be appealing. Nearly 65% of outstanding global green bonds are denominated in euros, reflective of the domicile of many green bond issuers as well as the demand from investors in that region. However, that market has been characterized by extremely low or even negative interest rates in recent years, making it more difficult to justify taking on currency and duration risk within a fixed income portfolio. In fact, nearly 30% of the global green bond market provided negative yields as of July 31, 2019. Currency hedged strategies may provide a solution, but not without cost, added complexity and potentially unanticipated tax consequences.
USD Green Bonds: A More Attractive Risk/Reward Profile vs Global Bonds
Source: S&P Dow Jones Indices as of 7/31/2019. USD Green Bonds is represented by the S&P Green Bond U.S. Dollar Select Index. Global Green Bonds is represented by the S&P Green Bond Select Index.
ESG Investing Solution: A USD-only Strategy
Fortunately, the U.S. dollar portion of the market has grown significantly in recent years, along with the broader market. This growth has allowed for the construction of liquid and diversified green bond portfolios. With a yield, duration and credit quality that is generally in line with the U.S. Aggregate Bond Index, investors can allocate a portion of their core bond portfolios into green bonds with little impact to their overall risk and return profile, providing sector diversification without adding currency risk or sacrificing yield.
Green Bond Allocation Impact
U.S. Aggregate Bonds: 100%
USD Green Bonds: 100%
USD Green Bonds: 20% U.S. Aggregate Bonds: 80%
Modified Duration (Yrs)
Source: S&P Dow Jones Indices, Bloomberg Barclays and Morningstar, as of 7/31/2019. Green Bonds are represented by the S&P Green Bond U.S. Dollar Select Index. US Aggregate Bonds are represented by the Bloomberg Barclays US Aggregate Bond Index. Investment Grade includes unrated bonds issued by U.S. government sponsored enterprises.
 Morgan Stanley Institute For Sustainable Investing
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Bloomberg Barclays U.S. Aggregate Index: tracks the investment-grade, U.S. dollar denominated, fixed-rate taxable bond market. The index includes U.S. Treasuries, government-related and corporate securities, mortgage backed securities (MBS) including agency fixed-rate and hybrid ARM Pass-throughs, asset backed securities (ABS) and commercial mortgage backed securities (CMBS) including agency and non-agency
S&P Green Bond Select Index: tracks bonds issued globally to finance environmentally friendly projects. To be eligible, the bond issuer must clearly indicate the intended use of proceeds and the bond must be flagged as “green” by the Climate Bonds Initiative, in addition to meeting minimum size requirements based currency. The index includes treasuries, government-related, corporate and securitized issues.
S&P Green Bond U.S. Dollar Select Index: tracks U.S. dollar-denominated bonds issued to finance environmentally friendly projects. To be eligible, the bond issuer must clearly indicate the intended use of proceeds and the bond must be flagged as “green” by the Climate Bonds Initiative, in addition to meeting minimum size requirements based currency. The index includes treasuries, government-related, corporate and securitized issues.
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