The growing importance of green bond funds

Dedicated green and sustainable bond funds have been part of the green bond market almost for as long as green bonds have existed. Still, it wasn’t until supply started picking up back in 2012-2013 that the trend of dedicated green bond funds started to take off.

Now, with supply increases in the green and sustainable bond markets hitting all-time highs, the funds are showing a similar momentum.

According to a recent survey by Environmental Finance, there are now more than 32 dedicated green bond funds, with total assets under management of over USD 8.2 billion. See the full list below.

Growing supply and demand lead to more funds

Low levels of supply and diversification were initially seen as a limitation for the dedicated funds, but that is no longer an issue, according to Bram Bos, senior lead green bond portfolio manager at NN Investment Partners (NN IP), one of the largest dedicated funds in the world.

“Initially demand came from the Netherlands, Sweden and France, but now it’s all of Europe, and Asia in particular. That’s a huge change,” Bos says.

In fact, demand for green bonds is so high that NN IP earlier this week opened its third green bond fund, having introduced its first in 2016. The growing size of the green bond market has made it easier to attract demand, according to Bos.

NN IP’s new fund comes just after Swedish asset manager Lannebo earlier in February announced the launch of its new actively-managed sustainable fund. The Lannebo Sustainable Corporate Bond fund will focus on corporate bonds, with an average credit score of investment grade. Karin Haraldsson and Katarina Ponsbach Carlsson will manage the fund, selecting green bonds as well as bonds issued by companies based on three main themes: better environment, healthier life and a sustainable society.

“We invested in the world’s first green corporate bond issued in 2013. Now we can have an entire fund only investing in sustainable bonds. That is fantastic,” says Haraldsson.

Market dynamics for green bond funds

The increasing demand from dedicated funds has made its mark on both the primary and secondary markets, according to Povl Bak-Jensen, head of syndicate at Nordea.

“All things equal, investor demand is higher for green bonds compared to non-green bonds, and the dedicated green investors in particular are more ‘sticky’ in their demand. This allows issuers to price their bonds more tightly in the primary market,” he says.

NN IP’s Bos recognises that, on a bond-for-bond basis, premiums are in fact lower for green bonds in the primary market. However, he also highlights that he is comfortable with that, as “there is overall more premium to play with as a result of sourcing a larger share of supply from the primary market relative to non-green bonds.”

The fact that there is less liquidity for green bonds in the secondary markets is well-known, although Nordea’s Bak-Jensen notes that “while it is true that we are seeing lower liquidity in green bonds in the secondary market, it is more aptly characterised as ‘asymmetric illiquidity.’ That is, the illiquidity is mainly only an issue if you are looking to buy.”

As for the overall concerns around risk-return, Bos says the results so far are proving the opposite. NN IP recently analysed how the Bloomberg Barclays MSCI Euro Green Bond Index performed compared to an index of euro-denominated corporate and sovereign bonds and found that green bonds generated returns of 7.4% compared to 6.0% for regular bonds in 2019.

However, managing a green bond fund does require additional time and resources to perform a proper green bond analysis, according to Bos. Besides the credit and ESG analyst, portfolio managers themselves need to understand the green impact and the alignment with the overall strategy, he says. Yet he sees this not as a drawback but an advantage.

“We as portfolio managers are much closer to the issuers. We know them very well, and they know us. It’s almost like a partnership rather than anonymously buying a bond in the market, and that really improves what you can achieve in terms of engagement,” he says.

Katarina Ponsbach Carlsson at Lannebo shares this view, noting, “We invest exclusively in corporate bonds issued by companies that we are familiar with and where we can see a tangible impact on at least one of our three themes.”

What does the future look like for green bond funds?

Looking ahead, it is fair to assume that the overall demand for green bonds will increase as investors become more focused on sustainability concerns. Also, as more issuers come to the market, especially corporate issuers, diversification becomes even less of an concern.

Bos shares this view, noting that growth is accelerating from both sovereigns and corporates, with some sectors, such as car manufacturing and metals/mining, having yet to enter the green bond market. For green bond funds, that means a larger size in the future as well as more sophisticated funds, he says. NN IP’s newly launched fund, for example, has a specific focus on corporate green bonds.

“While most funds are aggregated today, I expect green bond funds of the future to be more specialized, focusing on a particular subsector or issuer type. That, in turn, will likely make it easier for asset owners to include green bond funds in their asset allocation,” he says.

Another key development that will influence green and sustainable bond funds is the EU Taxonomy, which should help fund managers with the definitions of green and sustainable activities. Similarly, the forthcoming EU Green Bond Standard will raise the question of what green bond definitions are eligible for green bond funds.

Lannebo’s Haraldsson recognises these developments but notes that “while these will certainly help, we still rely on our own analysis and alignment with the Green Bond Principles as the primary source of guidance.”

Environmental Finance 2020 list of green bond funds:

Source: Environmental Finance