Green Bond Risk Premiums: A Twin-Bond ULFP Approach

60 minute read

Typically, green bonds trade with lower volatility than vanilla bonds, and as such issuers can issue green bonds at a lower cost of capital.

At the same time, if expected risk-return ratios do not deteriorate, investors can remain within their fiduciary duty limits.

We believe that properly accounting for volatility allows investors to switch back to the alignment of a green bond strategy with their own fiduciary duty risk-return obligations, rather than just a returns-based perspective.

Certain institutions, such as the Nordic Investment Bank and KfW, have set up green bond mandates to support the market, explicitly with the target to lower funding costs for green projects.

We believe these institutions' roles should be counter rather than pro-cyclical buyers of green bonds. In other words, they should construct their investment plans to be activated when other buyers are absent and deactivate them when markets are more balanced.

In this way, they could provide better liquidity (and lower volatility) in green bonds vis-a-vis traditional bonds specifically in downside scenarios, and through this channel provide arguments for issuers of green bonds to get a lower cost-of-capital.