Millions of investors have embraced socially responsible investing, preferring to put their money into stocks of firms that don’t sell weapons, alcohol or tobacco. But few investors are as familiar with a kind of second cousin: green bonds.
Like all bonds, green ones are loans from investors to issuers, with interest paid to bond owners for a given period before the principal is repaid. But green bonds are used to raise money for projects deemed good for the environment, like cleaning up pollution, supporting agricultural or forestry projects, or countering the effects of climate change.
Issuance of green bonds has soared alongside concerns about climate change, from about $800 million in 2007 to about $150 billion in 2017, according to Van Eck Securities Corp., which offers an exchange-traded fund, VanEck Vectors Green Fund (ticker: GRNB) composed of green bonds.
[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]
Most green bonds are taxable, like ordinary government and corporate bonds, but there is a relatively small subset of tax-free municipal green bonds, with no tax on interest earnings and capital gains tax if a bond is sold for more than was paid. Like ordinary munis, tax-exempt green bonds appeal to investors seeking steady income. Tax exemption on interest is more valuable for investors in higher tax brackets.
While green bonds are issued for specific projects, in most cases their interest payments, and therefore their creditworthiness, or safety, are not dependent on the success of the project but on the financial health of the issuer, adding a degree of safety for investors concerned the project doesn’t look like a sure thing.
The vast majority of green bonds are rated as investment grade. Issuers include major corporations such as Apple ( AAPL), as well as governmental bodies and the World Bank.
Van Eck says green bond features like duration and yield are typically similar to those of comparable “plain vanilla” bonds, meaning investors have not had to sacrifice investment results to support environmentally beneficial projects. GRNB, for instance, yields about 1.4 percent, Van Eck says, about the same as ETFs with ordinary bonds.
“There is not a significant difference between conventional bonds and green bonds in terms of structure, risk/return potential, and so on,” says Katrina Sheehan, vice president at PNC Asset Management Group and adjunct professor of finance at Cleveland State University.
“The only major variation stems from what green bonds are — a financing source for companies and local governments to fund environmentally-friendly projects,” she says. “It is thus assumed that any funds received from a debt issue can only be utilized for that project, it cannot be used for any other operational needs. With that, there are generally higher transparency requirements for these issues.”
She says green bonds are suitable for investors with environmental, social or governance concerns (ESG investing).
“Green bonds can be a long-term holding just as any other fixed income asset class, with the primary goal being responsible investing in addition to total return,” she says, noting that although track records are short, these bonds should perform much like ordinary bonds from the same issuers.
A non-profit organization called the Climate Bonds Initiative has list of green bonds on its website.
“Investors looking to direct investments toward projects that have an environmental focus should consider green bonds,” says Nick Erickson, head of tax-exempt ESG investing at Sage Advisory, an asset management firm in Austin, Texas.
[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]
“I would caution investors to do their due diligence on the issuance and look past the label to ensure that the proceeds are in fact going to be used as intended,” Erickson says. “Since reporting is not mandatory, nor standardized, there can be instances of Green labeled bonds where the proceeds may be diverted away from the intended Green project.”
Here are things for an investor to consider:
What type of bond? Is the bond a “full recourse” bond backed by the issuer, or do interest earnings rely on the success of the project funded?
How healthy is the issuer? Researching green bonds is similar to that for ordinary bonds, and investors should look at the issuer’s credit rating and other financial data.
Are they liquid? That means is there a big enough demand to assure you can buy and sell when you want? “We view liquidity as likely being the largest potential risk,” Sheehan says. “This is a fairly thin market with few issuers currently, which may make trading more challenging.”
What is the duration? That’s a measure of “interest-rate risk” or the chances a bond will lose value if newer bonds pay more interest. A five-year duration, for example, means the bond could lose 5 percent of its value for every one-percentage point rise in prevailing interest rates.
Is the issuing country stable? Because so many of these bonds are issued by foreign governments or companies, investors should consider risks of economic or political instability, or warfare, as well as the possibility that a profitable investment could turn into a loser due to changes in exchange rates.
What is the fund’s expense ratio? As with all mutual funds or ETFs, green funds charge an expense ratio that chews into returns. All else being equal, a smaller ratio is better.
What is the tax treatment? Is the bond or fund tax-exempt? Some funds have a mix of taxable and tax-exempt bonds, making it hard to forecast tax bites in the future.
Is the project really green? While the Climate Bonds Initiative certifies bonds as green, some bonds labeled green by issuers are less green than others, according to an assessment by Scotland-based Aberdeen Asset Management. It cites a bond issued by the state of Victoria in Australia to pay for electric railroad projects.
While that sounds green, closer inspection showed the power to come from coal-burning generators, which is not at all green, Aberdeen says.
[See: 7 of the Best Socially Responsible Funds.]
“Brown bonds doesn’t sound quite as catchy,” Aberdeen says.
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8 Facts to Know About Green Bonds originally appeared on usnews.com
