Practical analysis for investment professionals
08 October 2019

Green Bonds vs. Traditional Bonds

We need your help. The puzzle we address below has confounded us for some time. So please share your views and comments at the end of this post.

Are environmental, social, and governance (ESG) investing returns higher, lower, or the same as those of comparable traditional investments?

This question is the source of constant debate. Because ESG investing integrates non-traditional sources of risk that are not always priced by the market, some theorize that ESG approaches might generate higher returns than traditional assets.

How do we test this hypothesis?

The simplest way is to look at bonds. Many issuers issue traditional as well as certified green bonds that explicitly contribute to ESG-related goals. Municipalities, states, governments, and development banks, among other international organizations, issue bonds that are linked to specific projects.

If the same issuer sells traditional and green bonds, both varieties have identical credit risk from the issuer’s perspective. But the traditional bonds may have higher (lower) yield than the green bonds. What’s the source of this higher (lower) risk in traditional bonds? Maybe investors view ESG risks differently.

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Green bonds from the same issuer do indeed trade at lower yields, or higher prices, compared to their non-green counterparts, according to a Bank for International Settlements (BIS) study. But while green bond yields at issuance were between 10 bps (AAA-rated issuers) to 45 bps (A- and BBB-rated issuers) lower than those of non-green bonds from the same issuer, the variance of this premium was very high. With a 27 bps standard deviation between issuers, the observed green bond premium was not statistically significant.

On the other hand, studies of US corporate and municipal bonds show green bonds trade at a yield premium relative to non-green bonds. Two researchers from the Sorbonne found an 8 bps average yield premium for green vs. non-green bonds from the same issuer.

Analysis from University Paris-Dauphine examined bonds issued by French companies that, because of regulatory changes, had to provide more transparency into their ESG risks. The authors found no yield premium for green bonds or bonds of companies with lower ESG risks in the market.

This result echoes that from a new study of US municipal bonds by David F. Larcker and Edward M. Watts from Stanford University. The advantage of this study is that it examined munis that were issued by the same issuer at virtually the same time. Some tranches of munis were certified green, others weren’t.

The study’s exclusive focus on US munis constituted its key drawback: US munis are almost exclusively bought by US taxable investors directly or through intermediaries, mutual funds among them. Because US munis are exempt from federal, state, and municipal taxes when bought by investors who live in the issuing state or municipality, they are particularly attractive to high-income US households.

Larcker and Watts found virtually no difference between the yields of green and non-green bonds once the controlled bond pairs in the comparison sample are properly adjusted for such fixed features as callability terms and other specific tax differences.

Yield Differences: Green vs. Non-Green Muni Bonds with Identical Risk

Source: David F. Larcker and Edward M. Watts, “Where’s the Greenium.”

These results sparked some discussion between the two of us as we worked on a related ESG investing project. The question we kept coming back to: Why do green bonds have no observable risk premium or discount?

We found that these studies measure performance based on radically different assumptions about investor preferences in the green bond market. We believe that a better understanding of how investors assess performance might provide important clues to determine how to measure this ever-illusive green premium.

And this is where we need your help.

What struck us was that there may be structural differences between investors that buy green bonds and those that buy traditional bonds. This raised a host of questions we’d like your input on.

Are there any studies that explore why investors buy green bonds to begin with? Do you work at an organization that invests in green bonds and are willing to share why and how you invest in them? What goals do investors pursue with green bonds? Are they motivated by risk management or something else? Does it just make them feel good?

And do you hold green bonds to maturity or actively trade in them to maximize total return measured over shorter intervals?

And what about the systemic differences between issuers of green and traditional bonds? Why issue green bonds at all? Do managers at these companies have different incentives?

As active participants in the green bond market, we want to hear your views on how it has evolved over time. Have you seen improvements in depth and liquidity?

We will try to collate and otherwise organize your responses and come back with more focused questions. Hopefully, in time, we together can build a more accurate picture of green bond market structure, one that goes beyond routine statistics.

Please email [email protected] with your answers and opinions. We will collect and summarize them in a future post so that we can all benefit from the collective wisdom.

For more on environmental, social, and governance (ESG) investing, check out Handbook on Sustainable Investments from the CFA Institute Research Foundation.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Bill Fung, PhD

Bill Fung, PhD, is a trustee of the CFA Institute Research Foundation. He earned a PhD in mathematics from London University and a PhD in finance from the University of Manchester. Prior to joining the investment banking industry in the mid 1980s, he held visiting as well as permanent faculty positions at both UK and US universities. Fung joined the hedge fund industry in the early 1990s as a hedge fund partner and subsequently as co-CEO of a fund of hedge funds. He maintained his research interest and co-authored several awarding winning papers on hedge fund strategies (with David A. Hsieh) including a Graham and Dodd Scroll Award and the CAIA 2015 Research Excellence Award. Fung served on the editorial board of the Financial Analyst Journal prior to his retirement and continues to referee papers for the Journal.

Joachim Klement, CFA

Joachim Klement, CFA, offers regular commentary at Klement on Investing. Previously, he was CIO at Wellershoff & Partners Ltd., and before that, head of the UBS Wealth Management Strategic Research team and head of equity strategy for UBS Wealth Management. Klement studied mathematics and physics at the Swiss Federal Institute of Technology (ETH), Zurich, Switzerland, and Madrid, Spain, and graduated with a master’s degree in mathematics. In addition, he holds a master’s degree in economics and finance.

5 thoughts on “Green Bonds vs. Traditional Bonds”

  1. Soniz Akin says:

    Dear Mr. Fung,
    Dear Mr. Klement,

    I have read your article with interest and I am asking myself the same questions as you have made it in your article.

    I would like to write my master thesis about green bonds and I am actually at this time looking for good research questions which are possible to answer.

    I have seen a lot of studies which investigated if there is a greenium or not, but actually there is no greenium as you also have mentioned it in your article.

    I also have thought that it would be really interesting why investors are buying green bonds and which motives are driving them to do so. But the problem is, how should a student like me reach big investors which are investing in fixed income instruments..

    Therefore I would really appreciate any input from your side, since you both are experts in the green bond market.

    Can I may ask you which research direction would be really interesting and help to develop the green bond market? Or which questions regarding the green bond market are still not answered but should be?

    Which articles and journals do you recommend to go into the green bond market in depth (despite from them which you have already mentioned)?

    I really really appreciate any given input. You would help me a lot!

    Thanks and best regards from Austria (Vienna)
    Soniz Akin

  2. Rajeev says:

    As an investor, I want the return and safety of my capital. From the looks of it, the traditional bond seems to offer as such. Thus, a non-traditional bond seems to do the job for me. ESG may be for those who want to make a difference but are also willing to lose some yield in the process.

  3. Hunar says:

    Best way to share Green Bonds vs. Traditional Bonds. Are traditional bonds more safer then Green bonds. As Green bonds market is up. So in your thought where investment will be good.

  4. Chiu Ying Wong says:

    There are too many articles that list the reasons for investors to buy green bonds, but not enough arguments on why issuers should issue green bonds instead of regular bonds. Perhaps because green bonds can get buyers more easily than regular bonds, since many government and multilateral agencies have funds allocated for green financing? but green bonds, if properly issued, come with an undertaking to report its impact. Indeed, with green washing a concern now, the burden for reporting will get heavier. So, to promote green financing in developing countries like the Philippines, how do we make green bond issuing easier and attractive to induce local companies to formulate green projects is an important question.

  5. Kenneth Anderson says:

    This article was written in 2019.

    Do the authors have any updated conclusions on yield difference for Green and Ordinary bonds?

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