The peculiar growth of greeniums

Posted 12 August 2022

The global push towards sustainability has expanded the investment universe to include a wide range of environmental, social and governance (ESG) linked vehicles. An increasingly important and growing asset class within this trend has been the issuance of green bonds, which operate in a similar way to traditional bonds that also provide the additional benefit of contributing to environmentally positive outcomes.

The case for sustainable investing is compelling, which can often be supported by government-backed incentives and regulation, so its unsurprising that investor allocations to green bonds have grown significantly to gain ESG exposure within their fixed income allocations.

However, this demand has led to a curious dislocation, whereby green bonds have, in some cases, been trading at a premium over their vanilla (non-ESG) counterparts whereby the investment yield is lower. This phenomenon has become known as a ‘greenium’.

A greenium is defined as the spread between the interest rates of a green bond and a vanilla bond from the same issuer. Or, in other words, the amount of return investors are willing to forego to gain exposure to a green asset.

The rationale behind this might be that investors have recognised the direction of travel, that the ESG investment universe is likely to keep expanding, often supported by government initiatives that also look to improve the sustainability of businesses in the future. Conversely, investments that are unable or less equipped to meet the evolving ESG criteria are increasingly being frozen out by investors for fear of contagion risk sweeping across low-ESG assets.

Issuers of green bonds have gone further than their peers with regard to setting science-based targets (SBTs) on topics such as the transition to net zero and enlisting external verifications on their progress. These initiatives have been greeted, pardon the pun, warmly by investors.

But what does the greenium mean for investment managers?

Firstly, it reinforces the need to hold issuers to account on matters such as setting SBTs and providing clear and quantifiable evidence. It also places additional value on external third-party verifications and the use of process (UoP) clauses.

From an investment perspective, we acknowledge that by taking an active approach to issuance selection we will be better placed to avoid the more expensive issues. In turn, it helps us to identify where a greenium may become priced in after purchase.

We recognise the notion of paying a greenium may sound counterintuitive to some, as the theory behind ESG investing is that sustainable practices can improve long-term returns. But, if improving sustainability reduces risk, it is logical that the yields on these lower-risk instruments are lower.

Companies are under increasing pressure and scrutiny from both local and international regulators to improve their sustainability practices and reporting. If conformity to these higher standards leads to lower funding costs, it would likely encourage businesses to transition their models towards more sustainable practices and futureproof them against forthcoming regulations.  

We do however need to remain cognisant of the supply and demand relationship. Green bonds carry the same credit risk as their vanilla equivalents, and consider whether the targets or transparency of the issue warrants paying a greenium. It’s also worth noting that bonds unable to meet the issuer’s ESG targets run the risk of being called or could lead to the issuer facing higher penalties for missing specific targets leading to higher yields. As an investor there needs to be a focus on the ability for businesses to actually attain their stated goals with the potential penalties punishing enough to ensure the businesses follow through with their intentions.

The difference between investment grade and high-yield green bonds is also at the forefront of our minds, particularly as the latter tend to be more emissions sensitive. Green investment in the high yield space could potentially be more impactful, so investors may be willing to accept a higher greenium despite the increased credit risk.

Overall, despite the relative novelty of the term, the fundamentals of fixed-income investing remain. Issuer credit quality analysis remains just as important despite the added emphasis on sustainability goals.

Anthony Graham  

Fund Research Analyst