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.
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.
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
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 firstname.lastname@example.org 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.
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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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Professional Learning for CFA Institute Members
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, is a trustee of the CFA Institute Research Foundation and 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.