Tag: coupon price

Posted on

The economics of ‘greeniums’ in sustainable finance: doing good has a price

Sustainability has become one of the most pressing issues facing society. Patterns of human production and consumption have become unsustainable. On the environmental front, climate change, land-use change, biodiversity loss and depletion of natural resource are destabilising the Earth’s eco-system.

Furthermore, data on poverty, hunger and lack of healthcare show that many people live below minimum social standards. This has led to greater emphasis being placed on sustainable development: ‘development that meets the needs of the present without compromising the ability of future generations to meet their own needs’ (The Brundtland Report, 1987: Ch.2, para. 1).

The financial system has an important role to play in channelling capital in a more sustainable way. Since current models of finance do not consider the welfare of future generations in investment decisions, sustainable finance has been developed to analyse how investment and lending decisions can manage the trade-off inherent in sustainable development: sacrificing return today to enhance the welfare of future generations.

However, some commentators argue that such trade-offs are not required. They suggest that investors can ‘do well by doing good’. In this blog, I will use ‘green’ bonds (debt instruments which finance projects or activities with positive environmental and social impacts) to explain the economics underpinning sustainable finance and show that doing good has a price that sustainable investors need to be prepared to pay.

I will analyse why investors might not be doing so and point to changes which may be required to ensure financial markets channel capital in a way consistent with sustainable development.

The growth of sustainable finance

Sustainable finance has grown rapidly over the past decade as concerns about climate change have intensified. A significant element of this growth has been in global debt markets.

Figure 1 illustrates the rapid growth in the issuance of sustainability-linked debt instruments since 2012. While issuance fell in 2022 due to concerns about rising inflation and interest rates reducing the real return of fixed-income debt securities, it rebounded in 2023 and is on course for record levels in 2024. (Click here for a PowerPoint.)

Green bonds are an asset class within sustainability-linked debt. Such bonds focus on financing projects or activities with positive environmental and social impacts. They are typically classified as ‘use-of-proceeds’ or asset-linked bonds, meaning that the proceeds raised from their issuance are earmarked for green projects, such as renewable energy, clean transportation, and sustainable agriculture. Such bonds should be attractive to investors who want a financial return but also want to finance investments with a positive environmental and/or social impact.

One common complaint from commentators and investors is the ‘greenium’ – the price premium investors pay for green bonds over conventional ones. This premium reduces the borrowing costs of the issuers (the ‘counterparties’) compared to those of conventional counterparties. This produces a yield advantage for issuers of green bonds (price and yield have a negative relationship), reducing their borrowing costs compared to issuers of conventional bonds.

An analysis by Amundi in 2023 using data from Bloomberg estimated that the average difference in yield in developed markets was –2.2 basis points (–0.022 percentage points) and the average in emerging markets was –5.6 basis points (–0.056 percentage points). Commentators and investors suggest that the premium is a scarcity issue and once there are sufficient green bonds, the premium over non-sustainable bonds should disappear.

However, from an economics perspective, such interpretations of the greenium ignore some fundamentals of economic valuation and the incentives and penalties through which financial markets will help facilitate more sustainable development. Without the price premium, investors could buy sustainable debt at the same price as unsustainable debt, earn the same financial return (yield) but also achieve environmental and social benefits for future generations too. Re-read that sentence and if it sounds too good to be true, it’s because it is too good to be true.

‘There is no such thing as a free lunch’

In theory, markets are institutional arrangements where demand and supply decisions produce price signals which show where resources are used most productively. Financial markets involve the allocation of financial capital. Traditional economic models of finance ignore sustainability when appraising investment decisions around the allocation of capital. Consequently, such allocations do not tend to be consistent with sustainable development.

In contrast, economic models of sustainable finance do incorporate such impacts of investment decisions and they will be reflected in the valuation, and hence pricing, of financial instruments. Investors, responding to the pricing signals will reallocate capital in a more sustainable manner.

Let’s trace the process. In models of sustainable finance, financial instruments such as green bonds funding investments with positive environmental impacts (such as renewable energy) should be valued more, while instruments funding investments with negative environmental impacts (such as fossil fuels) should be valued less. The prices of the green bonds financing renewable energy projects should rise while the prices of conventional bonds financing fossil-fuel companies should fall.

As this happens, the yield on the green bonds falls, lowering the cost of capital for renewable-energy projects, while yields on the bonds financing fossil-fuel projects rise, ceteris paribus. As with any market, these differential prices act as signals as to where resources should be allocated. In this case, the signals should result in an allocation consistent with sustainable development.

The fundamental point in this economic valuation is that sustainable investors should accept a trade-off. They should pay a premium and receive a lower rate of financial return (yield) for green bonds compared to conventional ones. The difference in price (the greenium), and hence yield, represents the return investors are prepared to sacrifice to improve future generations’ welfare. Investors cannot expect to have the additional welfare benefit for future generations reflected in the return they receive today. That would be double counting. The benefit will accrue to future generations.

A neat way to trace the sacrifice sustainable investors are prepared to make in order to enhance the welfare of future generations is to plot the differences in yields between green bonds and their comparable conventional counterparts. The German government has issued a series of ‘twin’ bonds in recent years. These twins are identical in every respect (coupon, face value, credit risk) except that the proceeds from one will be used for ‘green’ projects only.

Figure 2 shows the difference in yields on a ‘green bond’ and its conventional counterpart, both maturing on 15/8/2050, between June 2021 and July 2024. The yield on the green bond is lower – on average about 2.2 basis points (0.022 percentage points) over the period. This represents the sacrifice in financial return that investors are prepared to trade off for higher environmental and social welfare in the future. (Click here for a PowerPoint.)

The yield spread fluctuates through time, reflecting changing perceptions of environmental concerns and hence the changing value that sustainable investors attach to future generations. The spread tends to widen when there are heightened environmental concerns and to narrow when such concerns are not in the news. For example, the spread on the twin German bonds reached a maximum of 0.045 percentage points in November 2021. This coincided with the 26th UN Climate Change Conference of the Parties (COP26) in Glasgow. The spread has narrowed significantly since early 2022 as rising interest rates and falling real rates of return on bonds in the near-term seem to have dominated investors’ concerns.

These data suggest that, rather than being too large, the greeniums are too small. The spreads suggest that markets in debt instruments do not seem to attach much value to future generations. The valuation, price and yield of green bonds are not significantly different from their conventional counterparts. This narrow gap indicates insufficient reward for better sustainability impact and little penalty for worse sustainability impact.

This pattern is repeated across financial markets and does not seem to be stimulating the necessary investment to achieve sustainable development. An estimate of the scale of the deficit in green financing is provided by Bloomberg NEF (2024). While global spending on the green energy transition reached $1.8 trillion in 2023, Bloomberg estimates that $4.8 trillion needs to be invested every year for the remainder of this decade if the world is to remain on track under the ‘net zero’ scenario. Investors do not seem to be prepared to accept the trade-off needed to provide the necessary funds.

Can financial markets deliver sustainable development?

Ultimately, the hope is that all financial instruments will be sustainable. In order to achieve that, access to finance would require all investors to incorporate the welfare of future generations in their investment decisions and accept sacrificing sufficient short-term financial return to ensure long-term sustainable development. Unfortunately, the pricing of green bonds suggests that investors are not prepared to accept the trade-off. This restricts the ability of financial markets to deliver an allocation of resources consistent with sustainable development.

There are several reasons why financial markets may not be valuing the welfare of future generations fully.

  • Bounded rationality means that it is difficult for sustainable investors to assign precise values to future and distant benefits.
  • There are no standardised sustainability metrics available. This produces great uncertainty in the valuation of future welfare.
  • Investors also exhibit cognitive biases, which means they may not value the welfare of future generations properly. These include present bias (favouring immediate rewards) and hyperbolic discounting (valuing the near future more than the distant future).
  • Economic models of financial valuation use discount rates to assess the value of future benefits. Higher discount rates reduce the perceived value of benefits occurring in the distant future. As a result, long-term impacts (such as environmental conservation) may be undervalued.
  • There may be large numbers of investors who are only interested in financial returns and so do not consider the welfare of future generations in their investment decisions.

Consequently, investors need to be educated about the extent of trade-offs required to achieve the necessary investments in sustainable development. Furthermore, practical models which better reflect the welfare of future generations in investment decisions need to be employed. However, challenges persist in fully accounting for future generations and it may need regulatory frameworks to provide appropriate incentives for effective sustainable investment.

Articles

Report

Data

Questions

  1. Using demand and supply analysis, illustrate and explain the impact of sustainable investing on the markets for (i) green bonds and (ii) conventional bonds. Highlight how this should produce an allocation of finance capital consistent with sustainable development.
  2. Research the yields on the twin bonds issued by Germany since this blog was published. Can you identify any association between heightened environmental concerns and the spread between the ‘green’ and conventional bond?
  3. Analyse the issues which prevent financial markets from producing the pricing signals which produce an allocation of resources consistent with sustainable development.
  4. Research some potential regulatory policies which may provide appropriate incentives for sustainable investment.
Posted on

The bond roller coaster

To finance budget deficits, governments have to borrow. They can borrow short-term by issuing Treasury bills, typically for 1, 3 or 6 months. These do not earn interest and hence are sold at a discount below the face value. The rate of discount depends on supply and demand and will reflect short-term market rates of interest. Alternatively, governments can borrow long-term by issuing bonds. In the UK, these government securities are known as ‘gilts’ or ‘gilt-edged securities’. In the USA they are known as ‘treasury bonds’, ‘T-bonds’ or simply ‘treasuries’. In the EU, countries separately issue bonds but the European Commission also issues bonds.

In the UK, gilts are issued by the Debt Management Office on behalf of the Treasury. Although there are index-linked gilts, the largest proportion of gilts are conventional gilts. These pay a fixed sum of money per annum per £100 of face value. This is known as the ‘coupon payment’ and the rate is set at the time of issue. The ‘coupon rate’ is the payment per annum as a percentage of the bond’s face value:


Payments are made six-monthly. Each issue also has a maturity date, at which point the bonds will be redeemed at face value. For example, a 4½% Treasury Gilt 2028 bond has a coupon rate of 4½% and thus pays £4.50 per annum (£2.25 every six months) for each £100 of face value. The issue will be redeemed in June 2028 at face value. The issue was made in June 2023 and thus represented a 5-year bond. Gilts are issued for varying lengths of time from 2 to 55 years. At present, there are 61 different conventional issues of bonds, with maturity dates varying from January 2024 to October 2073.

Bond prices

Bonds can be sold on the secondary market (i.e. the stock market) before maturity. The market price, however, is unlikely to be the coupon price (i.e. the face value). The lower the coupon rate relative to current interest rates, the less valuable the bond will be. For example, if interest rates rise, and hence new bonds pay a higher coupon rate, the market price of existing bonds paying a lower coupon rate must fall. Thus bond prices vary inversely with interest rates.

The market price also depends on how close the bonds are to maturity. The closer the maturity date, the closer the market price of the bond will be to the face value.

Bond yields: current yield

A bond’s yield is the percentage return that a person buying the bond receives. If a newly issued bond is bought at the coupon price, its yield is the coupon rate.

However, if an existing bond is bought on the secondary market (the stock market), the yield must reflect the coupon payments relative to the purchase price, not the coupon price. We can distinguish between the ‘current yield’ and the ‘yield to maturity’.

The current yield is the coupon payment as a percentage of the current market price of the bond:


Assume a bond were originally issued at 2% (its coupon rate) and thus pays £2 per annum. In the meantime, however, assume that interest rates have risen and new bonds now have a coupon rate of 4%, paying £4 per annum for each £100 invested. To persuade people to buy old bonds with a coupon rate of 2%, their market prices must fall below their face value (their coupon price). If their price halved, then they would pay £2 for every £50 of their market price and hence their current yield would be 4% (£2/£50 × 100).

Bond yields: yield to maturity (YTM)

But the current yield does not give the true yield – it is only an approximation. The true yield must take into account not just the market price but also the maturity value and the length of time to maturity (and the frequency of payments too, which we will ignore here). The closer a bond is to its maturity date, the higher/lower will be the true yield if the price is below/above the coupon price: in other words, the closer will the market price be to the coupon price for any given market rate of interest.

A more accurate measure of a bond’s yield is thus the ‘yield to maturity’ (YTM). This is the interest rate which makes the present value of all a bond’s future cash flows equal to its current price. These cash flows include all coupon payments and the payment of the face value on maturity. But future cash flows must be discounted to take into account the fact that money received in the future is worth less than money received now, since money received now could then earn interest.

The yield to maturity is the internal rate of return (IRR) of the bond. This is the discount rate which makes the present value (PV) of all the bond’s future cash flows (including the maturity payment of the coupon price) equal to its current market price. For simplicity, we assume that coupon payments are made annually. The formula is the one where the bond’s current market price is given by:


Where: t is the year; n is the number of years to maturity; YTM is the yield to maturity.

Thus if a bond paid £5 each year and had a maturity value of £100 and if current interest rates were higher than 5%, giving a yield to maturity of 8%, then the bond price would be:


In other words, with a coupon rate of 5% and a higher YTM of 8%, the bond with a face value of £100 and five years to maturity would be worth only £88.02 today.

If you know the market price of a given bond, you can work out its YTM by substituting in the above formula. The following table gives examples.


The higher the YTM, the lower the market price of a bond. Since the YTM reflects in part current rates of interest, so the higher the rate of interest, the lower the market price of any given bond. Thus bond yields vary directly with interest rates and bond prices vary inversely. You can see this clearly from the table. You can also see that market bond prices converge on the face value as the maturity date approaches.

Recent activity in bond markets

Investing in government bonds is regarded as very safe. Coupon payments are guaranteed, as is repayment of the face value on the maturity date. For this reason, many pension funds hold a lot of government bonds issued by financially trustworthy governments. But in recent months, bond prices in the secondary market have fallen substantially as interest rates have risen. For those holding existing bonds, this means that their value has fallen. For governments wishing to borrow by issuing new bonds, the cost has risen as they have to offer a higher coupon rate to attract buyers. This make it more expensive to finance government debt.

The chart shows the yield on 10-year government bonds. It is calculated using the ‘par value’ approach. This gives the coupon rate that would have to be paid for the market price of a bond to equal its face value. Clearly, as interest rates rise, a bond would have to pay a higher coupon rate for this to happen. (This, of course, is only hypothetical to give an estimate of market rates, as coupon rates are fixed at the time of a bond’s issue.)

Par values reflect both yield to maturity and also expectations of future interest rates. The higher people expect future interest rates to be, the higher must par values be to reflect this.

In the years following the financial crisis of 2007–8 and the subsequent recession, and again during the COVID pandemic, central banks cut interest rates and supported this by quantitative easing. This involved central banks buying existing bonds on the secondary market and paying for them with newly created (electronic) money. This drove up bond prices and drove down yields (as the chart shows). This helped support the policy of low interest rates. This was a boon to governments, which were able to borrow cheaply.

This has all changed. With quantitative tightening replacing quantitative easing, central banks have been engaging in asset sales, thereby driving down bond prices and driving up yields. Again, this can be seen in the chart. This has helped to support a policy of higher interest rates.

Problems of higher bond yields/lower bond prices

Although lower bond prices and higher yields have supported a tighter monetary policy, which has been used to fight inflation, this has created problems.

First, it has increased the cost of financing government debt. In 2007/8, UK public-sector net debt was £567bn (35.6% of GDP). The Office for Budget Responsibility forecasts that it will be £2702bn (103.1% of GDP in the current financial year – 2023/24). Not only, therefore, are coupon rates higher for new government borrowing, but the level of borrowing is now a much higher proportion of GDP. In 2020/21, central government debt interest payments were 1.2% of GDP; by 2022/23, they were 4.4% (excluding interest on gilts held in the Bank of England, under the Asset Purchase Facility (quantitative easing)).

In the USA, there have been similar increases in government debt and debt interest payments. Debt has increased from $9tn in 2007 to $33.6tn today. Again, with higher interest rates, debt interest as a percentage of GDP has risen: from 1.5% of GDP in 2021 to a forecast 2.5% in 2023 and 3% in 2024. What is more, 31 per cent of US government bonds will mature next year and will need refinancing – at higher coupon rates.

There is a similar picture in other developed countries. Clearly, higher interest payments leave less government revenue for other purposes, such as health and education.

Second, many pension funds, banks and other investment companies hold large quantities of bonds. As their price falls, so this reduces the value of these companies’ assets and makes it harder to finance new purchases, or payments or loans to customers. However, the fact that new bonds pay higher interest rates means that when existing bond holdings mature, the money can be reinvested at higher rates.

Third, bonds are often used by companies as collateral against which to borrow and invest in new capital. As bond prices fall, this can hamper companies’ ability to invest, which will lead to lower economic growth.

Fourth, higher bond yields divert demand away from equities (shares). With equity markets falling back or at best ceasing to rise, this erodes the value of savings in equities and may make it harder for firms to finance investment through new issues.

At the core of all these problems is inflation and budget deficits. Central banks have responded by raising interest rates. This drives up bond yields and drives down bond prices. But bond prices and yields depend not just on current interest rates, but also on expectations about future interest rates. Expectations currently are that budget deficits will be slow to fall as governments seek to support their economies post-COVID. Also expectations are that inflation, even though it is falling, is not falling as fast as originally expected – a problem that could be exacerbated if global tensions increase as a result of the ongoing war in Ukraine, the Israel/Gaza war and possible increased tensions with China concerning disputes in the China Sea and over Taiwan. Greater risks drive up bond yields as investors demand a higher interest premium.

Articles

Information and data

Questions

  1. Why do bond prices and bond yields vary inversely?
  2. How are bond yields and prices affected by expectations?
  3. Why are ‘current yield’ and ‘yield to maturity’ different?
  4. What is likely to happen to bond prices and yields in the coming months? Explain your reasoning.
  5. What constraints do bond markets place on fiscal policy?
  6. Would it be desirable for central banks to pause their policy of quantitative tightening?