Warning: members of the public are being contacted by people claiming to work for AXA Investment Managers UK Limited.  Find out more information and what to do by clicking here.

How to integrate Green Bonds in a Global Allocation

  • 26 September 2023 (3 min read)

Key points:

  • Green bonds remain one of the most appropriate instrument to deliver environmental benefit while gaining access to a global, diversified and well-balanced universe
  • Investors’ appetite remains strong for the asset class, but they can face a tracking error dilemma
  • Green bonds combined with a small allocation to US Treasuries potentially offers the benefits of investing in green bonds while addressing the tracking error dilemma

Growth of the Green bond market and opportunities

Over the past few years, the green bond market has grown from a niche market to a credible alternative to the conventional bond market. So far this year, green bonds issuance is up 25% of the previous record levels reached in 2022 and 20211 thanks to continued credit sector diversification and increasing sovereign issuances. Historically, investors have been attracted to the asset class due to the benefit of higher transparency, the ability to track the projects financed, assess their environmental benefit, and measure it with clear KPIs.  Now, this trend of strong issuance levels allows green bonds to offer investors a global and diversified universe worth more than $1.4trn with more than 700 issuers.

Image

Source: AXA IM, Bloomberg as of 31 August 2023

Strong investors’ appetite

Institutional investors were the first to grasp the potential of the instrument in a context of growing awareness around climate change risks, increased demand for transparency and regulatory scrutiny. Yet, it did not take long for wholesale and retail investors to be won over by green bonds as well in a rush for credible sustainable investment solutions. As rates hit multi-year highs, green bonds now also offer the possibility to capture attractive yields levels and a decent pick-up compared to the conventional universe, at a moment when central banks are reaching their peak rates.

Image

Source: AXA IM, Bloomberg as of 31 August 2023

Yet, if some investors have the flexibility to build a custom allocation in which green bonds fit perfectly, many still run strategic asset allocations based on conventional benchmarks and face a tracking error dilemma.

The tracking error dilemma

While the green bond market may have converged towards the conventional bond market when it comes to average duration or ratings, some differences remain. The green bond universe is more concentrated towards euro and dollar currencies and offers higher exposure to credit debts than the conventional market.

Image

Source: AXA IM, Bloomberg as of 31 August 2023

These differences imply a close to 200bps tracking error between a global green bond and a global aggregate index. This did not translate historically into major performance differences with a correlation between the two universes over the past five-year standing at around 91%2 . Yet, the rebound in rates volatility seen in 2022 has highlighted that these differences should not be ignored when considering a green bond allocation against a conventional aggregate benchmark.

Combining green bonds with US treasuries

We believe there is a very simple way to allocate to green bonds while addressing this dilemma. We found that combining green bonds with US Treasuries should increase the performance correlation and decrease the tracking-error against a global aggregate universe. This combination addresses the two key differences we highlighted between green bonds and the conventional market with a very liquid and low-cost approach.

In order to define the most optimal allocation, we ran a series of portfolios combining green bonds with up to 40% US Treasuries. The results demonstrated that with up to 25% allocation to US Treasuries, tracking error should decline and performance correlation improve while maintaining a higher, or similar, yield level. Yet, when continuing to allocate more to US treasuries, it is likely the correlation will hit a cap before declining, and tracking error hits a floor.

Image

Source: AXA IM, Bloomberg as of 31 August 2023

We believe that a 75% allocation to green bonds combined with 25% US treasuries would be a potentially optimal way to gain exposure to green bonds, minimise tracking error, maximise correlation and preserve the yield of the resulting allocation. Indeed, such combinations should offer a 98% correlation with a global aggregate universe (up from 91% for green bonds alone) with 1% tracking error (half of what the green bond universe exhibited).

Looking forward

The green bond market has become increasingly dynamic and should continue to offer interesting investment opportunities going forward. The benefit of transparency, the measurability, competitive yields both in absolute and relative terms make this well-balanced universe particularly attractive for investors looking for attractive valuations and a credible sustainable solution. Whether they opt for a custom approach to the green bond universe or a combination strategy, we believe investors can take advantage of the universe with approaches that are innovative and yet straightforward.  

  • U291cmNlOiBBWEEgSU0sIEJsb29tYmVyZyBhcyBvZiAzMSBBdWd1c3QgMjAyMy4gSXNzdWFuY2UgbGV2ZWxzIHJlYWNoZWQgJDMwMGJu
  • U291cmNlOiBBWEEgSU0gYXMgb2YgMzFzdCBKdWx5IDIwMjM=

Have our latest insights delivered straight to your inbox

SUBSCRIBE NOW
Subscribe to updates.

Related Articles

Fixed Income

How to capitalise on euro credit opportunities in evolving markets

  • by AXA Investment Managers
  • 13 May 2024 (5 min read)
Fixed Income

Euro Long-Term Credit

  • by Benoit Guerineau, Pauline Parent
  • 09 May 2024 (5 min read)
Fixed Income

Emerging Market Debt: hope springs eternal

  • by Magda Branet
  • 12 April 2024 (5 min read)

    Disclaimer

    This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.

    Due to its simplification, this document is partial and opinions, estimates and forecasts herein are subjective and subject to change without notice. There is no guarantee forecasts made will come to pass. Data, figures, declarations, analysis, predictions and other information in this document is provided based on our state of knowledge at the time of creation of this document. Whilst every care is taken, no representation or warranty (including liability towards third parties), express or implied, is made as to the accuracy, reliability or completeness of the information contained herein. Reliance upon information in this material is at the sole discretion of the recipient. This material does not contain sufficient information to support an investment decision.

    Issued in the UK by AXA Investment Managers UK Limited, which is authorised and regulated by the Financial Conduct Authority in the UK. Registered in England and Wales No: 01431068. Registered Office: 22 Bishopsgate London EC2N 4BQ

    In other jurisdictions, this document is issued by AXA Investment Managers SA’s affiliates in those countries.

    Risk Warning

    The value of investments, and the income from them, can fall as well as rise and investors may not get back the amount originally invested. 

    Are you an IFA or other Professional Investor ?

    Are you a financial advisor, institutional, or other professional investor?

    This section is for professional investors only. You need to confirm that you have the required investment knowledge and experience to view this content. This includes understanding the risks associated with investment products, and any other required qualifications according to the rules of your jurisdiction.