EXPLAINING GREEN BONDS, IN THIS POST WE ARE GOING TO LOOK AT THE DIFFERENT TYPES OF GREEN BONDS, THIS WILL BE SIMILAR TO THE STUDY WE DID ON TYPES OF REGULAR BONDS EXCEPT THIS STUDY WILL BE GREEN BONDS.
GREEN BONDS WERE CREATED TO FUND PROJECTS THAT HAVE POSITIVE ENVIRONMENTAL AND OR CLIMATE BENEFITS. THE MAJORITY OF THE GREEN BONDS ISSUED ARE GREEN ‘USE OF PROCEEDS’ OR ASSET-LINKED BONDS. PROCEEDS FROM THESE BONDS ARE EARMARKED FOR GREEN PROJECTS BUT ARE BACKED BY THE ISSUER’S ENTIRE BALANCE SHEET.
What is ‘Earmarking’
Earmaking consists of funds (or capital) that are set aside to pay for a specific project or event. In some cases, the term is also synonymous with the word “flagged”, or “marked”, especially when used in certain congressional settings.
BREAKING DOWN ‘Earmarking’
Major financial institutions, as well as state or federal governments, will often earmark funds received from bond issuances to pay for certain projects. For example, a state may issue municipal bonds, and then earmark the funds received from the bonds’ sales to pay for a project such as a new road or bridge.
THERE HAVE ALSO BEEN GREEN “USE OF PROCEEDS” REVENUE BONDS, GREEN PROJECT BONDS AND GREEN SECURITIZED BONDS.
What is a ‘Revenue Bond’
A revenue bond is a municipal bond supported by the revenue from a specific project, such as a toll bridge, highway or local stadium. Revenue bonds are municipal bonds that finance income-producing projects and are secured by a specified revenue source. Typically, revenue bonds can be issued by any government agency or fund that is managed in the manner of a business, such as entities having both operating revenues and expenses.
BREAKING DOWN ‘Revenue Bond’
Revenue bonds, which are also called municipal revenue bonds, differ from general obligation bonds (GO bonds) that can be repaid through a variety of tax sources. While a revenue bond is backed by a specific revenue stream, holders of GO bonds are relying on the full faith and credit of the issuing municipality. Typically, since holders of revenue bonds can only rely on the specific project’s income, it has higher risk than GO bonds and pays a higher rate of interest.
Structure of Revenue Bonds
Generally, revenue bonds mature in 20 to 30 years and are issued in $5,000 units. Some revenue bonds have staggered maturity dates and do not mature at the same time. These are known as serial bonds.
For example, if a revenue bond is issued to build a new toll road, the tolls that are collected from motorists who drive on the road would be used to pay off the bond, after the building expenses have been paid. A primary reason for using revenue bonds is that they allow the municipality to avoid reaching legislated debt limits. An agency that is run solely on tax dollars, such as a public school, cannot issue revenue bonds, since these entities would be unable to pay off the bond using revenues from the specific project.
Real Life Examples
St. Louis, Missouri, engages in tax-exempt revenue bond financing. Typical projects funded this way are multi-family housing, in which at minimum of 20% of the units are set aside for households meeting income guidelines; publicly owned facilities; pollution control facilities; and various fixed assets such as land/buildings. The maturity of most of the issues is 20 to 30 years, and interest earned is generally tax-exempt from federal and most state income taxes. This also allows the issuer to pay a lower interest rate.
New York’s Metropolitan Transportation Authority (MTA) decided to offer Green Bonds in February 2016. The MTA is using the $500 million of proceeds to pay for planned infrastructure renewal projects, including upgrades on its railroads. The bonds, issued under MTA’s Transportation Revenue Bond, are backed by the agency’s operating revenue and subsidies received from New York State.
What are Project Bonds
An alternative source of financing infrastructure projects
The global financial crisis has resulted in stricter regulations on banks and their lending requirements which mean that infrastructure projects can no longer be funded by traditional debt alone. Other more innovative ways of funding need to be considered and implemented such as project bonds.
Project Bonds vs. Traditional Debt
Recent surveys suggest that infrastructure is beginning to be viewed as an asset class of its own and the allocation to this investment class is expected to increase significantly. However, the global financial crisis has resulted in stricter regulations on banks and their lending requirements which mean that infrastructure projects can no longer be funded by traditional debt alone and other more innovative ways of funding need to be considered and implemented.
Advantages of Project Bonds
Project bonds open up an alternative debt funding avenue to source financing for infrastructure related projects. Traditionally, deals have been financed through banks, however the implementation of Basel III regulations requires stricter monitoring and disclosures, ultimately leading to higher costs and higher capital requirements. These higher costs will be passed through to the project developers translating to diminished project IRR’s (internal rates of return). By accessing the institutional bond market, companies are potentially able to reduce the project funding cost.
Government and the banks alone cannot fund South Africa’s R3,4 trillion infrastructure program. The use of bonds allows project developers to tap into R3 trillion worth of assets under management by South African institutional investors. In addition, Sovereign Wealth Funds are beginning to invest directly into infrastructure projects, so this may also provide an additional source of funding for capital projects into the future.
Project bonds offer an opportunity for institutional investors to participate in infrastructure projects through listed, tradable securities that can offer superior risk-adjusted returns.
Challenges of using project bonds as a source of funding
The use of project bonds as a funding mechanism may be unattractive to investors with a lower appetite for risk which is inherently higher in the construction industry. Before the financial crisis, capital markets were seen to be less stable than debt markets, which have now changed given the reduction in global liquidity. Local institutional bond investors, while happy to take on performance risk, generally are not prepared to take on any form of construction risk.
Not all debt portions of these deals will be able to take advantage of this source of funding, but this mechanism will certainly provide benefits to the project developers in the form of potentially enhanced returns due to the lower cost of capital
AND LASTLY WE LOOK AT SECURITIZED BONDS
What is ‘Securitization’
Securitization is the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors, and this process can encompass any type of financial asset and promotes liquidity in the marketplace.
Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage’s inherent risk of default and then sell those smaller pieces to investors.
BREAKING DOWN ‘Securitization’
The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.
In securitization, the company holding the loans, also known as the originator, gathers the data on the assets it would like to remove from its associated balance sheets. These assets are then grouped together by factors such as time remaining on the loan, the level of risk, the amount of remaining principle, and others.
This gathered group of assets, now considered a reference portfolio, is then sold to an issuer. The issuer creates tradable securities representing a stake in the assets associated with the portfolio, selling them to interested investors with a rate or return.
Benefits to Creditors and Investors
Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations. The investors effectively take the position of lender by buying into the security. This allows a creditor to remove the associated assets from their balance sheets.
The investors earn a rate of return based on the associated principle and interest payments being made by the included debtors on their obligation. Unlike some other investment vehicles, these are backed by tangible goods. Should a debtor cease payments on his asset, it can be seized and liquidated to compensate those holding an interest in the debt.
Securitization and Risk
Like other investments, the higher the risk, the higher potential rate of return. This correlates with the higher interest rates less qualified borrowers are generally charged. Even though the securities are back by tangible assets, there is no guarantee that the assets will maintain their value should a debtor cease payment.
THE GREEN BOND MARKET HAS TAKEN OFF IN RECENT YEARS USD 42 BILLION ISSUED I 2015 AND AS OF SEPTEMBER OF 2016 THE ISSUANCE WAS TOPPING 50 BILLION AND MOVING FAST.
NOW SO WE UNDERSTAND GREEN BONDS ARE STANDARD BONDS BUT THEY HAVE A GREEN BONUS FEATURE. THE GREEN “USE OF PROCEEDS” BOND MARKET HAS DEVELOPED AROUND THE IDEA OF FLAT PRICING,, WHERE THE BOND PRICE IS THE SAME AS ORDINARY BONDS. PRICES ARE FLAT BECAUSE THE CREDIT PROFILE OF GREEN BONDS IS THE SAME AS OTHER VANILLA BONDS FROM THE SAME ISSUER. THEREFORE GREEN BONDS ARE PARI PASSU TO VANILLA ISSUANCES.
HERE IS A REFRESHER COURSE ON WHAT A VANILLA BOND IS
What is ‘Plain Vanilla’
Plain vanilla signifies the most basic or standard version of a financial instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, resulting in a more complex security.
BREAKING DOWN ‘Plain Vanilla’
For example, a plain vanilla option is the standard type of option, one with a simple expiration date and strike price and no additional features. With an exotic option, such as a knock-in option, an additional contingency is added so that the option only becomes active once the underlying stock hits a set price point.
LET’S MOVE ON TO HOW ARE BONDS CONSIDERED GREEN
Bonds are labelled green by the issuer and should be qualified as green by an independent party
Independent review (also known as Second Review or Second Opinion)
Issuers self-label bonds as green. At a minimum, issuers qualify the label by providing detail to investors on the green eligibility criteria for use of proceeds. Issuers can also provide a independent review on the green credentials of the use of proceeds.
For more details about the types of review see the below table
WHAT ABOUT THE INVESTOR APPETITE? LET’S HAVE A LOOK
Investors with $45trn of assets under management have made public commitments to climate and responsible investment – green bonds can help them achieve their pledges in fixed income
The key difference between conventional and green bonds is the specified use of proceeds. Investors are increasingly focused on integrating Environment, Social and Governance (ESG) factors into their investment processes. Green bonds meet these Environmental objects. Investors in green bonds benefit from:
. Funding green projects without taking any additional risk or cost.
. Greater transparency into a bond’s use of proceeds
. Meeting commitments as signatories of PRI (PRINCIPLES FOR RESPONSIBLE INVESTING) and IIGCC (INSTITUTIONAL INVESTORS GROUP ON CLIMATE CHANGE)
. Reporting on climate impact of fixed income investments to their end asset owner
. Huge demand for green bonds with most of the issues oversubscribed
The huge demand for these bonds is coming from a range of investors. Some examples include:
. Mainstream Institutional investors; Aviva, BlackRock, State Street
. Specialist ESG (Environmental, Social, Governance) and Responsible Investors; Natixis, Mirova, ACTIAM
. Corporate Treasury; Barclays, Apple
. Sovereign and municipal governments; Central Bank of Peru, California State Treasurer
. Retail investors; World Bank issuances for retail investors through Merrill Lynch Wealth Managers and Morgan Stanley Wealth Managers. IFC and SolarCity issuances for retail investors through Incapital.
WHO ARE THE GREEN ISSUERS?
For issuers the benefits of green bonds outweigh costs
Green bonds have some additional transaction cost because issuers must track, monitor and report on use of proceeds. However, many issuers, especially repeat green bond issuers, off-set this initial cost with the following benefits;
. Highlights their green assets/business
. Positive marketing story
. Diversify their investor base (as they can now attract ESG/RI specialist investors)
. Joins up internal teams in order to do the investor roadshow (environmental team with Investor relations and other business)
See the full list of green bonds issued here
WHAT ARE THE BEST PRACTICE GUIDELINES?
Best practice guidelines and growing need for universal definitions of green
Voluntary best practice guidelines called the “Green Bond Principles” were established by a consortium of investment banks: Bank of America Merrill Lynch, Citi, Crédit Agricole Corporate and Investment Bank, JPMorgan Chase, BNP Paribas, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, Mizuho Securities, Morgan Stanley, Rabobank and SEB. Currently, there are (link is external)55 members of the Principles. Ongoing monitoring and development of guidelines has since moved to an independent secretariat hosted by the International Capital Market Association (ICMA).
The Principles highlight the importance of tracking proceeds, allocated funds to eligible projects and providing periodic reports on use of proceeds.
The Green Bond Principles do not provide details on “green”. The green definitions are left to the issuer to determine. Broad green project categories suggested by the principles include:
. Renewable energy
. Energy efficiency (including efficient buildings)
. Sustainable waste management
. Sustainable land use (including sustainable forestry and agriculture)
. Biodiversity conservation
. Clean transportation
. Clean water and/or drinking water
. World Bank and IFC have their own criteria or definitions of eligible green projects. The Climate Bond initiative is also helping to fill this gap by providing green definitions that are sector specific, developed by scientists and industry experts, These are available as a public good on the CBI website.
ALRIGHT NOW WE UNDERSTAND GREEN BONDS A LITTLE BETTER I HOPE SO WE WILL MOVING RIGHT INTO WHERE ARE THEY? WHO IS ISSUING THEM? AND HOW ARE THEY TAKING OFF?
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