Green bonds allow investors to target their funding to specific projects that meet criteria for being beneficial to the environment.

That’s a good thing to do. Relative to other fixed income investments there is no increased cost or lost returns; an investor can do well while doing good.

All is not rosy, however. Investors need to be aware of some downsides to determine if green bonds are appropriate for their situation. Additionally, not all bonds are equally green; it behooves investors to do their homework to ascertain exactly what they are supporting. 

What is a Green Bond?

Green bonds are fixed income debt investments, no different operationally from other such securities.

Their difference is that the capital raised by the issue is specifically earmarked for projects or other endeavors that specifically benefit either the climate or the environment. 

Earlier iterations were climate focused and green bonds are sometimes referred to by the narrower moniker of climate bonds.

There are a wide range of projects that fall under the umbrella of green: sustainable building, clean water, clean energy, and a variety of other environmentally beneficial categories that encompass far more than greenhouse gas reduction. Green bonds is a more inclusive term. 

Academic studies have shown credit ratings for green bonds to be equivalent to other, non-green issues, from the same issuer. There is neither benefit nor harm, from a credit standpoint, to green bonds.

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Similarly, studies have shown no advantage nor disadvantage to rate or yield from these issues. Investors should note that there may be variances within the issues; the lack of significance on an overall basis does not preclude some individual issues having either favorable or unfavorable performances.

A potentially significant downside to green bonds is the relatively small percentage of the market that is green. As green bonds account for less than 1 percent of the bonds sold in the United States, there is not necessarily the liquidity that is inherent in broader issues.

Some green issues may not be readily sold; investors should be prepared to hold green bonds to maturity if necessary. An alternative to individual issues would be to invest through either green mutual funds or green exchange-traded funds (ETFs) to take advantage of their greater liquidity.

What Makes Green Bonds Green?

Being green is a voluntary proposition. Companies may seek to have bonds deemed green in several different ways.

Overall, the common framework comes from the International Capital Market Association (ICMA), which established and periodically updates the Green Bond Principles (GBP).

The ICMA also issues Social Bond Principles and Sustainability Bond Guidelines for debt-funded projects addressing social or sustainability issues, respectively. These bonds would be credentialed under their respective guidelines and not under the GBP.

For a bond to be issued under GBP, the issuer must be using the proceeds for projects that fall under one or more environmental areas detailed in the GBP.

Additionally the issuer must detail how they will adhere to guidelines under four areas: use of proceeds, process of evaluation and selection, management of proceeds, and reporting. 

The four criteria for the GBP are designed to provide transparency and accountability around the use of the funds for the specific stated environmental purpose.

Issuers may seek formal recognition of their green status under several levels.

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Different Forms of Being “Green”

Bonds can be classified as green under the GBP by undergoing external review. There are four levels of external review — not all greens are the same shade.

A secondparty opinion can be obtained from an independent party with environmental expertise. The party must be truly independent or detail any potential conflicts.

Typically a second-party opinion is an analysis of alignment with GBP and includes an evaluation of the environmental features or impacts of the projects funded by the issue. An opinion may also include an assessment of the issuer’s objectives and strategies for environmental sustainability.

A verification can be obtained by the issuer, typically with regard to one or more aspects of the issue and against a specific set of criteria. The verification can be for claims or statements made by the issuer with regard to the nature of the projects or the use of funds.

It may or may not include verification of statements as they relate to environmental sustainability. It is important for investors to note that a verification is limited to those specific items verified and not a global verification of the issue or issuer.

A certification can be obtained from the issuer from an accredited third party who reviews the issue against established criteria.

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The certifying agency tests the issue against established guidelines to issue the appropriate certification in alignment with the criteria. A certification may still be limited but is often broader than a verification. 

A scoring or rating can have the issue scored or rated by one of several established scoring or rating agencies. These ratings may be for an aspect of the program, such as reporting or use of funds, and is not necessarily a global review of all aspects of the issue. 

The issuer determines what type and level of third-party external review they wish to have undertaken, and the issuer absorbs any costs for the review.

The GBP does provide templates and frameworks to assist external reviewers and to help provide a level of consistency for those reviewers using the templates. These templates are available on the ICMA’s website.

The Limitations of Being “Green”

Green bonds are not just from green companies. The reviews and criteria to establish any of the forms of qualification to be identified as a “green” bond apply to the specific bond issue and not to the issuing organization itself.

An organization could engage in other activities that are not necessarily environmentally friendly or not otherwise socially responsible. 

There is no reason a company that would generally be considered to be in an environmentally unfriendly business can’t issue green bonds, as long as the funds are specifically used for an environmentally friendly purpose

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The scope of reviews varies greatly. Being green can come from review of only an aspect of the issue, not necessarily from a comprehensive review.

This doesn’t indicate a problem with the reviews; companies may be very conscious of the potential harm that could befall them if they were to try to skirt the intent of the GBP process and criteria.

It is incumbent on the investor to do their homework to ascertain exactly what the funds are being used for and what specifically any third-party review encompasses. 

The Bottom Line on Green Bonds

While experiencing great growth, green bonds still represent a very small portion of the fixed income market.

Investors can make use of these investments to make sure their investment is going toward environmentally beneficial causes, without taking on undo risk or sacrificing returns. 

In terms of downsides, the standout is the potential lack of liquidity for green issues due to the small market — but this should improve as green bonds continue to become a larger part of the debt investing landscape.

Investors can invest in green bonds and have greater liquidity by investing through a green bond mutual fund or ETF.

Some investors may prefer individual issues as the funds are directly going to an environmental purpose, as opposed to investing in a fund that purchases bonds where the money may have already been spent for that purpose. 

As there is neither a creditworthiness advantage or disadvantage, investors still need to do their homework to ascertain that the creditworthiness of any issue they are considering is in line with their risk profile and appropriate for their situation.

Green bonds present an opportunity for investors to make sure their funds are being used for environmentally friendly purposes and, in turn, to influence companies to invest into environmentally friendly projects as this funding continues to gain traction in the markets.

Investors who are willing to do the work to understand what they are getting can indeed do well while doing good.

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