- Stocks are rising
- Commodities and precious metals are stumbling
- Bonds are falling
- The smell of inflation is back in the air
- And the U.S. dollar is within arms-reach of parity with the Euro
|A “Green Garage” courtesy of The Wall Street Journal|
Climate Bonds Initiative (a leading London-based research organization in this area) thinks the market will more than double in 2015, to nearly $100bn after tripling in 2014 (see graph). Total issuance reached $24.5bn year-to-date as of August 2015, so it appears that forecast is untenable. The total addressable market amounts to over $0.5 trillion.
|Source: Climate Bonds Initiative, Barclays.|
What is a Green Bond?
Green Bonds (aka Climate Bonds) are fixed-income instruments whose proceeds go towards a benefit to the environment.
Green bonds are similar to other bonds. The main types are “Use of Proceeds”, Project Bonds and Securitized Bonds. Use of Proceeds use either dedicated revenue streams as collateral backing the bonds, or are standard bonds which are backed by all of the issuer’s cash flows. Project Bonds, as the name implies, are backed only by specific projects and not the issuer. Securitized Bonds are asset backed vehicles that are specially-structured and designed
The evolution of Green Bonds is similar to what has been seen for early stage industries. The modern Green Bond “movement” began in 2007 when supranationals, mostly highly-rated banks (e.g., European Investment Bank) issued their first bond. Years later the market broadened to public finance/municipal entities and corporates. During 2014, a corporate name issued the first high-yield bond. That year, 2014, was a key catalyst for Green Bonds as the market grew deeper and broader. It is very important for the Green Bond market to have corporates in the same manner that the junk-bond market propelled corporate financings during the 1980s (we’ll leave Michael Milken out of this one!)
|Proceeds by Issuer Type (source: Climate Bonds Initiative)|
The U.S. Green Bond market
The U.S. took a back-seat during the Green Bond market’s early years. The Europeans have taken the lead due to their socialist nature (see chart below from Climate Bonds Initiative). Several European asset owners and investment managers have signed on to the United Nations Principles for Responsible Investment (PRI) initiative. Furthermore, European governments have encouraged (via subsidies) socially responsible investing and green projects such as solar power, wind, etc. Though recently, large liberal States (and cities) of California and Massachusetts have issued municipal Green Bonds. Given the overall SRI movement in the U.S. and the influence of large pension finds (i.e., TIAA-CREF) corporate issuers are expected to become a larger contributor to the overall Green Bond market.
At this time, the only investment vehicle that focuses in Green Bonds is a mutual fund called Calvert Green Bond (CGAFX). The fund has underperformed, partially due to its high front load (3.7%) though it has underperformed other funds too. It invests 90% of its assets in the U.S. and has an effective duration (maturity) of 5 years.
Recently, Ameriprise Financial subsidiary (Columbia Threadneedle) opened a new muni fund called Columbia U.S. Social Bond Fund which utilizes ESG criteria.
Where do we go from here
The Green Bond market was born in Europe, broadened in the U.S. but it will reach escape velocity in Asia. During 1Q’14, Toyota Motor Corp. issued the market’s first ABS, backed by auto leases. The proceeds were earmarked towards electric vehicles. Despite its $1.8bn size, the Japanese market will pale in comparison to the tidal-wave of Green Bonds emerging in China, according to a study conducted by The Intl. Institute for Sustainable Development.
Anyone that has ever visited China or ran the Beijing Marathon could see for themselves that pollution is a BIG problem. Some observers say environmental costs may be as high as 10% of GDP. Consequently, the Chinese State Council announced plans to grow a corporate Green Bonds market as part of its Five-Year Plan. There are several drivers that are expected to quicken this pace including:
Transport, primarily rail, will be a dominant way of reducing emissions in China, according to the IEA. Despite declining rates of rail investments here in the U.S., China recently added 6,000 km of high-speed rail track – which is double the ROW.
|Beijing Marathon’14 (Reuters)|
Green Standards Need to be Refined Yet Again
There are several standards that define what exactly (or not so exactly) a Green Bond is. The most popular are the Green Bond Principles and Climate Bonds Standard. There are also Green Bonds indices in which investors can determine if a particular bond is an index component. Both sets of standards are evolving and voluntary. The Climate Bonds Standard was developed by the Climate Bonds Initiative. It is very focused on Green Bonds from solar and wind companies and needs to be broadened to other industries such as transport, water, agriculture, etc. The Green Bonds Principles were developed by the ICMA and represents over 50 large financial institutions. It is a set of Best Practices for determining what is a Green Bond as well as the process of issuance, management of proceeds and reporting. The Green Bonds Principles were updated on March 27, 2015. I read them and thought I had mistakenly read the executive summary as they were too general in scope.
When Green Bonds go Bad
There are several ways a Green Bond could turn ugly. For example, bond proceeds may be diverted from their original noble cause towards activities that are not green. Green-proceeds may also be loosely-tracked and mixed with an issuer’s other bond proceeds. Reporting may not be transparent enough and assurances may not be objective or from a reputable third-party. While the above risks are valid, I believe they could be lessened over time. But there is an even greater overarching issue…
Is Green Bond investing really Socially Responsible Investing?
The short answer is a resounding No!
Socially Responsible Investors seek to purchase those companies that are practicing ESG (Environment Social Governance). These are companies that are striving to reduce their carbon-footprint, treat their employees (and community) well, and become more transparent. Few companies attain five-stars in all three letters, so investors emphasize certain areas. But overall, SRI asset managers tend to judge the whole company. The website Socially Responsible Investing, for example, focuses on how companies treat their employees because I believe if you don’t treat your own well you will never treat society well either. Others focus on companies with a mixed track-record that are progressing towards social responsibility. Apple under Tim Cook is a good example of this. Again, these asset managers are focusing on the merits of the whole company.
The overriding problem with Green Bond investing is that any company (or municipal) could issue such a bond so long that its proceeds go towards benefiting (i.e., less harm) the environment. With this type of definition, I cannot see a case that a borrower can not issue a Green Bond. So if oil company BP Plc wants to issue a Green Bond to make a new efficient LEED-class building (something it may have been planning anyway) socially responsible asset managers would be allowed to purchase those bonds. (In fairness to the Calvert Green Bond fund, I had conversations with its lead portfolio manager and Chief Investment Officer Fixed Income (Catherine Roy) who understood my issues, but stated that Calvert has experience in SRI and would ensure that it was buying bonds of companies that are socially responsible overall.)
However, the Barclays MSCI Green Bonds Index does address the issue of whether or not the whole company is green-bond worthy in its 90% Rule. This rule says that a general obligation bond is Green if 90% of its revenues fall under one of its five eligible economic categories. While I give kudos to Barclays for both addressing the whole issuer and for listing specific economic categories and subcategories, they are too lenient determining whether a whole issuer is Green. For example, using its subcategories, a company is Green if it sells superconductors or building-insulation.
The Case of the Green Parking Garage
In March’15, the WSJ highlighted green bonds sold by Massachusetts (Salem State University) whose proceeds would be used to build a garage with electric-car charging stations. Officials said the garage would reduce pollution by cutting down students’ circling the parking lot looking for spots. However, environmental advocates noted that having a parking garage still encourages people to drive and create greenhouse gases.
Green Bond investing properly executed will continue helping the broader investment world adopt SRI. However, investors should fully understand the issuer’s core business. Otherwise, these bonds will just be Greenwashing the issuer’s dirty laundry.
How about the Debt Ceiling with all your might?
When will the European Crises hits its nexus?
According to behavioral finance, trend theory, etc.., I believe this will most likely occur during the second week of February 2012.
Market indices (both equities, bonds and capital markets overall) are likely to have their usual Christmas Rally and January Effect during the next several weeks. Then sometime after January it’ll all be over.
Background to the Euro-Crises:
Many reasons have been cited for the Euro-Crises, with the “blame-game” starting in the U.S. (i.e, Wall Street exported it’s derivatives/mortgage mess) to changes in regulations, i.e., the Basel Accords. Basel II essentially said that Banks didn’t need to set aside any capital for sovereign debt, but lots of capital for most other debt. This diverted loans from corporates towards Sovereigns.
However, we do not accept these arguments, as most just look to shift blame. We
believe the Euro Crises stems from economic mismanagement and lack of fiscal discipline. In the same light of weight-gain, we believe the aptly-named PIIGS of Europe were glutenous for debt.
|thanks to Mighty Lists blogs!|
Individual countries are accountable for their actions. However, the root cause perhaps came from a “Group Think” mentality, whereby the Eurozone was created with a Monetary Union (i.e, European Central Bank, Euro common currency) but no fiscal union. We believe fiscal integration and intergovernmentalism is a political impossibility. The Maastricht Treaty via its “convergence criteria” limits budget deficits to 3% of GDP and Debt to 60% of GDP. However, this is not legally enforceable, and so failed (see chart). (All of the charts can be enlarged by clicking on them.)
|Source: Eurostat, WSJ|
Further, a Monetary union without a Fiscal union is a fundamentally flawed model. This led to many consequences including a large current account (i.e. trade balance) in Germany and negative current accounts with the PIIGS. Historically, the German D-Mark would have risen, while the others would decline, thus realigning trade flows. Germany is a clear beneficiary of this model’s flaw.
The EU has given the world a daily dose of ideas that increased capital market volatility. Two examples are listed below:
Below are listed recent data suggesting Europe’s Crises will soon worsen:
1.) Italy’s Term Structure of Credit Risk has inverted. That is, Italian short-term sovereign bond yields (and CDS prices) are higher than its long-term yields. (Note that typically yields/CDS prices rise as tenures lengthen). So what’s happening? When ST yields (or CDS prices) are > LT yields this means investors are looking for a near-dire situation short-term, but expecting LT improvement. This phenomenon is an inversion of the Term Structure of Credit Risk. See charts below:
|source: WSJ, November 30, 2011|
According to the table below, Italy’s near-term CDS is trading at approximately the “Ba” equivalent rating, however, note the sample size is small below Baa.
2.) European banks are insolvent as per Basel III regulations: This means not only lower capital, but a reverse multiplier-effect (i.e., less lending). Even officials from the IMF are worried.Article I, Article II.
3.) Asset Correlations increase significantly during Crises. This is occuring now.Article. Higher correlations (and market volatility) typically surround a Crises. In fact, S&P is now rating European economies in one basket, placing 15 EU nations on Negative-CreditWatch.
4.) The US equity market declined during Thanksgiving week, the worst since 1942. (Thanksgiving wasn’t recognized as an official holiday until 1942.) Such abnormal price-action is usually indicative of worse times to come.
5.) European Bond Yields and Credit Default Swaps are significantly higher, and rising rapidly. CDS prices for Europe should be under 100bps. Italy’s bond yields and CDS are hovering at 7% and 470bps, respectively. Note that Italy is the third largest bond(Article) market in the world. Italy is also subject to “hot money” as over 40% of bond market participants are outside the country including Hedge Funds and Asset Managers. Italy is too big to Bail.
6.) The mighty Germany had a failed Bond Auction two weeks ago. See foxbusiness story. Again, fundamentally this shouldn’t have happened, indicating cracks in the internals of the market.
7.) Austerity plans won’t work as tax revenues are likely to decline due to recent evidence Europe is rapidly falling into recession. Lower economic growth will cause sovereign borrowing rates to rise, in turn choking economic growth (i.e, a negative feedback loop). We base this on data provided by OECD and Markit Economics.
8.) Since June’11, liquidity has declined rapidly. Money Market funds that buy USD commercial paper have changed their purchasing behavior due to new Basel regulations that require they hold shorter-term securities, and that they have higher cash reserves. (We note though that the recent USD/EUR currency swaps recently set up with Central Banks appear to be temporarily alleviating the situation.)
8a) Further, Asset Managers, Commercial Banks and other long-term holders of debt are also expected to drain liquidity from the global market. This is because as part of the Greek bailout (and quasi-bankruptcy) Greek Credit Default Swaps could not be redeemed, as a Credit Event would not be triggered under ISDA. Click Here for Press Release. Consequently, professional investors can no longer hedge their European exposure.
9.) Counting on China as a European savior is no longer an option. China’s “growth-at-all-costs” model is showing signs of fatigue, according to Markit. The government just lowered reserve-requirements(link) to keep its own Bubble from bursting. Politicians must also deal with social unrest, especially as its economic growth nears the key 7% level which is needed to maintain social stability, according to Time Magazine.
While the Euro-Crises has evolved over the last two years, the Crises has worsened to the Point of No Return. The EU can no longer continue “playing chicken” with the market. Times have changed – China can no longer afford to save Europe, borrowing rates are unaffordable and the Eurozone is entering recession just as austerity plans are kicking-in. Europe can no longer save the world from itself !