Fixed Income

Felix Matthys

Lecture: Green Bonds

Lecture Outline

1 Green Bonds: Definitions and Market Overview

2 The pricing of green bonds

3 Is there really a greenium in the data

Felix Matthys & David Chesman Fixed Income ITAM 2 / 26

What Makes a Green Bond green?
Recent development in corporate finance: Issuance of corporate green bonds.
Most common definition: ”Vague” commitment to using bond proceeds to fund
environmental projects, for instance renewable energy, green buildings, or resource
conservation
When is a bond really a green bond?
• No universally recognized definition for what makes a bond green! No universally
recognized definition for what makes a bond green!
: Problematic as investors are uncertain about whether bond is truely green
(”Green-washing”)
: This could reduce demand for green bonds

Comparing ”Normal/Standard” Bonds and ”Green” bond

• Green bonds identical financial features
: Full recourse goes to the issuer, not to revenues derived from a specific project
: No particular “green” covenants or legal ramifications that bind issuers to their
sustainability promises.

: If they have exactly the same payoff characteristics and risks, whouldn’t their price
(yields) have to be the same?

🤔
Felix Matthys & David Chesman Fixed Income ITAM 3 / 26
Green bond issuance

Historical Development:
• Corporate green bonds were
essentially inexistent prior to
2013 (total issuance of
corporate green bonds was
about $5B.)
• Since then, the issuance of
corporate green bonds has
skyrocketed!
• In 2018 alone, the corporate
sector issued green bonds
worth $95.7B.

Source: Climate bond Initiative Green Bond Pricing in the Primary Market
Jan-Jun 2021

Felix Matthys & David Chesman Fixed Income ITAM 4 / 26

How to Issue a Green Bond?
To qualify as a “certified” green bond, companies have to
• undergo third-party verification to establish that the proceeds are funding projects
that generate environmental benefits,

: raises administrative and compliance costs!

Given the constraining nature of green bonds, is it really worth it?

Felix Matthys & David Chesman Fixed Income ITAM 5 / 26

How to Issue a Green Bond?
To qualify as a “certified” green bond, companies have to
• undergo third-party verification to establish that the proceeds are funding projects
that generate environmental benefits,

: raises administrative and compliance costs!

Given the constraining nature of green bonds, is it really worth it?

Consider the following (seemingly superior) strategy:

(I) issue a conventional bond,
(II) invest the proceeds in green projects if they are deemed to be financially more
viable than other projects

: No need to issue a green bond in the first place (avoid costly green bond issuance
procedure)

Felix Matthys & David Chesman Fixed Income ITAM 5 / 26

Possible Reasons why to Issue Green Bonds
So, what are the rationales for issuing corporate green bonds, and what are their
implications?
I Supply side:
• Signaling argument: green bonds may serve as a credible signal of the company’s
commitment towards the environment.
: An argument against greenwashing: Getting the green certificate is costly
• Cost of capital argument: if green bond investors are willing to trade off financial
returns for societal benefits, companies may issue green bonds to obtain cheaper
financing.
I Demand side:
• Investor preference ”for being green”
• These benefits could be in the form of psychological benefits for investors,
brand value, influence with regulators, or other indirect gains (non monetary
benefits).
• Are green bonds are actually less risky or volatile than otherwise similar
conventional bonds?
: If so, inclusion of green bonds could be used to serve as a stabilizing force in
a portfolio which is attractive for investors
• Do they help mitigate / hedge climate change risk?
: If so, green bonds should trade at a lower yield as they offer protection
against climate change risk
Felix Matthys & David Chesman Fixed Income ITAM 6 / 26
Is there Demand for Green Bonds?
Yes, there is a lot!

• Green bonds in both EUR

and USD attracted larger
book cover and exhibited
larger spread compression on
average, than standard bonds
Source: Climate bond Initiative Green Bond Pricing in the Primary Market
Jan-Jun 2021

In the EU: In the US:

• Average over-subscription was 2.9x for
green bonds, and 2.6x for standard
bonds. Spread compression averaged
20.4bps for green bonds and 19.6bps
for standard bonds.
• Average over-subscription was 4.7x for
green bonds and 2.5x for vanilla
equivalents. Spread compression
averaged 29.9bps for green bonds and
24.8bps for standard bonds.

: Results seem to suggest that there is indeed a financial benefit of being green!

Felix Matthys & David Chesman Fixed Income ITAM 7 / 26

The Greenium
An astonishing finding: Green bonds trade at a premium, termed the Greenium,
relative to comparable non- green bonds!

Greenium: Definition
G(t, T ) := rng (t, T ) − rn (t, T ), where rng (t, T ) is the yield of a green bond

Felix Matthys & David Chesman Fixed Income ITAM 8 / 26

The Green Yield Curve

Source: Climate bond Initiative Green Bond Pricing in the Primary Market Jan-Jun 2021

Felix Matthys & David Chesman Fixed Income ITAM 9 / 26

What do these empirical observations imply?

This has important implications:

: It pays to be green even though issuance costs are higher!
: Investor demand for ”being” green is very large (higher than demand for
comparable standard bonds)
: Results in lower cost of capital

Felix Matthys & David Chesman Fixed Income ITAM 10 / 26

Who is benefiting the most from Issuing Green bonds?

Felix Matthys & David Chesman Fixed Income ITAM 11 / 26

Risk and Return Analysis of Green Bonds

Remarks:
• Green bonds exhibit very similar risk and return statistics compared to regular
bonds

Felix Matthys & David Chesman Fixed Income ITAM 12 / 26

The pricing of green zero bonds
Recall: The price of the standard zero bond is given by

Pz (t, T ) = NZ (t, T )

where Z (t, T ) denotes the discount factor at time t with maturity T

• Question here: How can a green bond trade at a premium when its characteristics
are the same as standard bond?
This implies the following result

Greenium for zero coupon bonds

If green zero bonds are traded at a premium relative to otherwise identical standard
bonds, we have that
Pzg (t, T ) > Pz (t, T ) (1)
then it must be the case that
r g = r + G,
where r g is the yield on the green bond and G denotes the greenium.
• If G>0 then the green bond is trading at a discount relative to a standard bond
• If G<0 then the green bond is trading at a premium relative to a standard bond

Felix Matthys & David Chesman Fixed Income ITAM 13 / 26

Exercise (Derivation of the Greenium)
Show that, starting from equation (1), that it must be the case that

r g < r , where r g is the yield on the green bond

Hint: Use continuously compounded interest rates

Felix Matthys & David Chesman Fixed Income ITAM 14 / 26

The pricing of green coupon bonds
Recall: The price of a coupon bond is given by
m m
c X c X
!
Pc (t, Tm ) = N Z (t, Ti ) + Z (t, Tm ) = Pz (t, Ti ) + Pz (t, Tm )
n i=1 n i=1
where m = b(T − t) × nc is the total number of coupon payments over the lifetime of the bond.

Greenium for coupon bonds

If green coupon bonds are traded at a premium relative to their otherwise identical, we have that
g
Pc (t, T ) > Pc (t, T )

then it must be the case that for at least some maturities Ti , i = 1, . . . , n,

r g (t, Ti ) < r(t, Ti ),

where r g (t, Ti ) is the yield on the green bond. In this setup, the greenium
G(t, Ti ) := r g (t, Ti ) − r(t, Ti ), is not constant and varies with the maturity Ti

• We can no longer derive an explicit expression for the greenium in the case the bonds pay
coupon
• Even if we use one single interest rate, i.e. the yield to maturity on these bonds, the
greenium can only be determined numerically
• The result stated above says that not all the zero rates on the green bonds r g (t, Ti ) have
to be smaller than their corresponding zero rates r g (t, Ti ) extracted using standard bonds
Felix Matthys & David Chesman Fixed Income ITAM 15 / 26
Equilibrium Analysis: Green vs. Standard Bonds
How can we rationalize the greenium in the data, i.e. model preferences of investors for
green bonds?
: Study supply and demand for bonds
Denote by X g the quantity of green bonds demanded, the demand and supply curves are
given by
• Supply: Pz (t, T ) = KS0 + KS1 X g , KS0 , KS1 > 0
• Demand: Pz (t, T ) = KD0 + g − KD1 X g , g ≥ 0, KD0 , KD1 > 0
where g is preference parameter for green bonds and
How is the equilibrium determined: Supply = Demand!
g + KD0 − KS0
X g∗ = ,
KD1 + KS1
where we require that KD0 > KS0 such that the quantity of green bonds remains
positive,
It is easy to see that investors with higher preferences for green bonds demand more of
them
: Higher price → lower yield for green bonds

Felix Matthys & David Chesman Fixed Income ITAM 16 / 26

 Demand and Supply for Bonds
120
Demand (no preferences)
100
Demand (with preferences)
Supply
Price of Bond

80

60

40

20

0
0 2 4 6 8 10 12 14 16 18 20

Quantity X

Felix Matthys & David Chesman Fixed Income ITAM 17 / 26

Is there really a greenium in the data
The answer to this question is: It depends!

Source: Facts and Fantasies about the Green Bond Premium

: There is no consensus
Felix Matthys & David Chesman Fixed Income ITAM 18 / 26
Is there really a Greenium in the data

Source: Facts and Fantasies about the Green Bond Premium

: Greenium very large during the recent Covid-19 crisis

Felix Matthys & David Chesman Fixed Income ITAM 19 / 26
Bond Portfolio Returns: Comparison

Source: Facts and Fantasies about the Green Bond Premium

: Green portfolio outperformed standard bond portfolio in the years 2018 and 2020

Felix Matthys & David Chesman Fixed Income ITAM 20 / 26

Bond Portfolio Returns: Comparison

Source: Facts and Fantasies about the Green Bond Premium

• Left figure (2018): In 8 weeks out of 13, the green portfolio has outperformed by
6 bps on average peaking at 14 bps in the midst of the 2018 crisis.
• Right figure (2020): during the first six weeks of the Covid-19 crisis that began in
mid-February, the green portfolio has outperformed 6 weeks out of 6 by 4.6 bps on
average peaking again at the height of the crisis.
: It appears that green bonds provide a hedge!

Felix Matthys & David Chesman Fixed Income ITAM 21 / 26

Breakdown of the Green: Currency

Is there a greenium present in all the major currencies?

Source: Facts and Fantasies about the Green Bond Premium

• The greenium seems to be only present in bonds issued in Euros

Felix Matthys & David Chesman Fixed Income ITAM 22 / 26

Breakdown of the Greenium: Time-to-Maturity

Is there a greenium present for any maturity T ?

Source: Facts and Fantasies about the Green Bond Premium

• The greenium seems to be present for medium - to longer maturity bonds

Felix Matthys & David Chesman Fixed Income ITAM 23 / 26

Breakdown of the Greenium: Sector
How does the greenium vary across sectors?

Source: Facts and Fantasies about the Green Bond Premium

• The greenium seems to be present in a few sectors!

Felix Matthys & David Chesman Fixed Income ITAM 24 / 26

Breakdown of the Green premium: Credit Rating

Does the credit rating affect the greenium?

Source: Facts and Fantasies about the Green Bond Premium

• Green bonds issued by firms with relative low credit ratings, exhibit a higher
greenium than when a firm with a very high credit rating issues green bonds

Felix Matthys & David Chesman Fixed Income ITAM 25 / 26

Summary

Key concepts:
X Green bonds: Bonds are called green when their proceeds are usedto fund
environmental projects, for instance renewable energy, green buildings, or
resource conservation
X Greenium: Empirical observation that green bonds tend to trade at a premium
relative to comparable standard bonds
X Investor preferences for green bonds: One possible explanation as to why green
bonds trade at a premium is because investors derive non pecuniary benefits from
holding green bonds
X Where can the greenium be found? It is still disputed as to whether a greenium
really exists. Certainly not in all fixed income markets

Felix Matthys & David Chesman Fixed Income ITAM 26 / 26