Tiny green-bonds market looking ready to sprout

Money managers, institutional investors and others are combining efforts to drive the nascent green-bonds market forward, and the fruits of their labor are becoming apparent.

Several new institutional strategies being developed that include green bonds could be launched this year, according to several sources. Recent government initiatives around the world promise to add liquidity to a relatively tiny market estimated at $3.5 billion to $5 billion. Furthermore, industry standards are being proposed to attract more institutional investors, who have remained aloof so far, with a few notable exceptions.

The definition of green bonds varies widely, but in general, they are issued to raise capital to fund specific projects aimed at reducing climate change. So far, most programs are dedicated to infrastructure improvements, either globally or within the country in which the bonds are issued.

Because of its relative new existence, managers generally have not used green bonds in their portfolios. However, the ability for such fixed-income instruments to provide attractive returns at relatively low risk, in addition to diversification characteristics and potential to tap into emerging-markets growth, helped heighten interest among managers such as State Street Global Advisors and Calvert Investments.

Nikko Asset Management Co. Ltd. in February 2010 was the first to offer an institutional strategy investing in green bonds. The strategy, which has about £400 million ($650 million) in assets, returned 11.6% in its first year, outperforming its benchmark by 90 basis points.

“The beauty of World Bank green bonds lies in their simplicity,” according to Stuart Kinnersley, chief investment officer of Nikko Asset Management Europe Ltd. “They are uncomplicated fixed-income securities traded in the same way as conventional bonds and backed by a [AAA-rated] supranational.”

Some large pension funds have directly invested in green bonds, but their exposure has been minimal. The funds include the $150.1 billion California State Teachers’ Retirement System, the $140.6 billion New York State Common Retirement Fund, the $41.4 billion United Nations Joint Staff Pension Fund, the 222 billion Swedish krona ($35.7 billion) AP Fonden 2 and the 220.8 billion krona ($35.5 billion) AP Fonden 3. In all cases, the green-bonds allocation likely is less than 1% of each fund’s entire fixed-income portfolio, sources said.

At AP3, executives initially began investing in green bonds issued by The World Bank Group in 2008 and have been gradually building the portfolio since. The green-bonds strategy, which includes securities denominated in krona and U.S. dollars, totals about 840 million krona ($135 million). In comparison, the fund’s entire fixed-income allocation stood around 75 billion krona ($12 billion) at the end of 2010. Under Swedish law, AP3 is required to invest at least 30% of its portfolio in fixed income.

“We consider the risk/return characteristics of the green bonds [issued by The World Bank] to be quite safe, with the potential for better performance, compared to some other government bonds,” said Christina Kusoffsky Hillesoy, head of communications and sustainable investments at AP3.

Managers such as SSgA are exploring the possibility of offering green-bonds strategies. Chris Mc-Knett, vice president and head of environmental, social and governance investing at SSgA, said green bonds are “an interesting application of sustainability in fixed income.”

“We think it’s an area that’s poised to grow considerably,” Mr. McKnett added. “We’re doing our homework and testing demand.”

He characterized investors as being “intrigued but are largely taking a “wait and see’ attitude.”

SUBSTANTIAL ACCELERATION

Christopher Flensborg, head of sustainable products and product development at Swedish financial institution Skandinaviska Enskilda Banken AB, said he expects demand for green bonds to “accelerate quite substantially” in 2011 and 2012. “If you take the increasing pressure for stakeholders to be aware of the risk profile of their investments, the increasing environmental concern and the fiduciary responsibilities — those three things are addressed in one instrument, which is green bonds,” said Mr. Flensborg, who helped engineer the green bonds issued by The World Bank.

The size of the investible green-bonds market has been one of the key problems for institutional investors. But there are some signs that more quality issuers are emerging.

In the latest example, the British government is proposing a national green investment bank capable of issuing green bonds. India and Canada also are considering similar moves aimed at luring institutions to invest in clean energy, several sources said.

The World Bank launched its first tranche of green bonds in December 2007 and remains the largest issuer, with $2 billion in total, according to World Bank data.

Other financial institutions that have issued green bonds include the European Investment Bank, Asian Development Bank, Nordic Investment Bank and African Development Bank.

GOVERNMENT BONDS

In 2009, the Treasury Department authorized about $2.2 billion of clean-renewable-energy bonds. They are different from bonds issued by The World Bank in that they are basically tax credit bonds, on which interest is paid in the form of federal tax credits instead of interest paid by the issuer.

Under a separate program, local governments in the U.S. can raise money for real estate energy efficiency improvements with property-assessed-clean-energy bonds.

Within the Build America Bonds program, certain portions qualify as green investments, according to Paul Hilton, director of sustainable-investment business strategy at Calvert.

“This is a critical time in the development of green bonds … We’re seeing initiatives all over the world, so it’s a good time for those of us who are committed to bringing [green bonds] to the market” for institutional investors, said Mr. Hilton, whose company is planning to launch a segregated environmental, social and governance bond strategy within the next month that will include green bonds.

Dollar-denominated World Bank green bonds outperformed U.S. Treasuries by about 40 basis points in 2010. Meanwhile, the krona-denominated bonds underperformed Swedish government bonds by about six basis points.

“We would invest more in green bonds, but the challenge has been finding [issues] that meet our criteria,” Ms. Hillesoy said. “We expect a little bit better returns, compared to the equivalent government bonds, but with the same risk/return characteristics. We also need to have confidence that the institution issuing the bonds can actually do the due diligence or we could have unforeseen reputational risk.”

At CalSTRS, fund executives have invested about $10 million so far and are poised to increase holdings in green bonds “as market opportunities present themselves,” according to spokesman Ricardo Duran.

“Our investment staff will look at these opportunities on a case-by-case basis to determine their fit to our strategy,” he added.

Stephanie Pfeifer, executive director of The Institutional Investors Group on Climate Change, said other obstacles for institutions include pricing, size of issues, currency movements, country risk and duration. All of these “will restrict the ability of investors to allocate capital,” she said. The network of about 70 members, including pension funds and money managers, dedicated to apportioning portfolios to address climate change.

NO STANDARD

Investors said there also is a lack of standardization among the issuers of green bonds, making it difficult to determine how “green” the associated low-carbon projects are. To tackle this problem, The Climate Bonds Initiative last month published a draft proposal for an industrywide compliance standard — the International Standards and Certification Scheme for Climate Bonds — to allow for more transparency and consistency, said Sean Kidney, co-founder of the initiative, which seeks to promote investments in green bonds. The first certified-bond issuance likely is to occur next month.

“The introduction of a standard at this early stage, we hope, will allow investors and other stakeholders to readily and quickly determine what’s kosher and what’s not” in climate bonds investing, Mr. Kidney said.

If the roadblocks to investing in green bonds can be removed, these securities “could sit very well within occupational pension funds’ portfolios,” said Penny Shepherd, chief executive at U.K. Sustainable Investment and Finance, an industry group promoting ESG investing. “What’s attractive are the predictable income flows and the inflation-linked potential.”

Thao Hua is a reporter at sister publication Pensions & Investments.