Despite the Federal Reserve’s commitment to normalizing interest rates, corporations can still borrow money at costs near multi-generational lows. Ultra-low yields and the prospect of rising interest rates make it a seller’s market for bonds and force buyers to do some serious homework.
With corporations taking advantage of a decade of low rates to extend maturities, buyers have little option but to snap up what’s offered. This holds particularly true large institutions whose policies require that they maintain a sizable allocation to fixed-income securities.
In recent years, issuers with strong balance sheets have been able to bide their time when credit markets tighten and wait for conditions to improve.
So-called green bonds—loosely defined as debt tied to renewable-energy or other environmentally friendly projects—have emerged as one of the fixed-income market’s hottest segments in this environment.
Bloomberg New Energy Finance estimates that issuers placed $28.8 billion worth of these bonds in the first quarter, an $8 billion increase from year-ago levels. Nevertheless, green bonds represent a small fraction of the global fixed-income market.
Assuming this run rate continues, total green-bond issuance would exceed $120 billion this year, up from $95.7 billion last year and $49.6 billion in 2015.
What’s driving this growth?
On the buy side, corporate and government investment policies have contributed to the popularity of green bonds. Socially responsible investing (SRI) mandates, which avoid putting money to work in industries that might conflict with certain values, have existed for decades.
Although these approaches narrow the universe of potential securities, investors have avoided some industries that have cracked up, including asbestos manufacturing and, in recent years, coal mining. Over the years, SRI strategies have expanded to include funds that use religious values as a rubric.
SRI measures have also appeared with increasing regularity on the annual ballots of corporations, with an emphasis on improving the transparency of disclosures related to long-term sustainability. For example, efforts have intensified to force Exxon Mobil Corp (NYSE: XOM) to revalue its reserves to reflect potential stranded costs related to climate change.
Green bonds are the latest iteration of SRI. To date, many of these bond issues have supported water treatment and pollution mitigation projects. But a growing proportion of this paper is tied to renewable-energy projects, land preservation and public transportation.
Five years ago, financial institutions accounted for the preponderance of green-bond issuance. But electric utilities took the top spot in the first three months of 2017. Energy, technology, and materials companies have also started to issue green bonds.
Municipal issuers in the US also play an important role in the market, with New York, California and Massachusetts leading the way.
For issuers, the appeal is simple: Robust demand for green bonds translates into lower coupon rates than regular bonds of equivalent maturities and credit quality.
Consider a utility that’s already started to de-carbonize its operations in response to regulation and/or to reduce costs and future risk by phasing out older, less-efficient coal-fired power plants. Leaning on the green-bond market to finance these projects can lighten the load significantly.
Among utilities, Enel (Milan: ENEL, OTC: ENLAY), Berkshire Hathaway (NYSE: BRK A, BRK B)-owned MidAmerican Energy, Iberdrola (Madrid: IBE, OTC: IBDRY) and privately held TenneT Holdings have dominated this segment of the bond market. But Southern Company (NYSE: SO), Duke Energy Corp (NYSE: DUK) and other publicly traded US utilities have also joined the green-bond party.
Duke Energy’s remaining fleet of coal-fired power plants and environmental damage related to its coal-ash ponds have prompted at least one sovereign wealth fund to dump the utility’s common stock. A well-targeted issue of green bonds would enable the North Carolina-based utility to tape this investor base at an even lower cost of capital
Of course, lower coupon rates translate into lower returns for investors in green bonds. Although holding these securities might make sense for an insurance company looking to meet its expected obligations in 20 years, these bonds represent a worse deal for ordinary investors than regular investment-grade paper.
But utilities and other corporations can unlock value for their shareholders by participating in the green-market. At the 2016 edition of the Edison Electric Institute’s annual financial conference (see my top takeaways and best ideas), a number of sessions and conversations focused on the advantages of the green-bond market.
One of the higher-yielding equities in our Aggressive Income Portfolio provides financing for energy-efficiency and renewable-power projects, primarily to municipalities and investment-grade corporate entities.
This business development company’s profits depend on the difference between its cost of capital and the interest rates on the loans it extends to customers. The lower coupons associated with green bonds could increase this outfit’s profit margins significantly.
The company tapped the green market for the first time this year, issuing more than $80 million worth of 20-year green bonds at a coupon rate of barely 4 percent—an impressively low cost of capital for an entity that lacks an investment-grade credit rating.
This lower cost of capital likewise helps the company to avoid chasing risky projects to boost its returns. Access to lower-cost financing also results in lower rates for its customers, which could encourage them to increase the number of projects on their plates.
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What kind of legs does the green bond market have?
With state, local and federal government entities likely forced to do more with less under the Trump administration, a relatively small investment in energy efficiency can pay off quickly. And if a federal infrastructure program relies heavily on the private sector, the market for low-cost green bonds could expand.
Utilities have every incentive to tap the green-bond market, especially if the Federal Reserve continues to increase the benchmark interest rates. Some of our favorite names in this sector continue to plow money into renewable-energy sources to de-carbonize and reduce their costs—a lower cost of capital will only sweeten the deal.