Darkest before Dawn: A difficult year for green bonds but the outlook is optimistic

Since the beginning of the year, fixed income has been massively impacted by a historic rise in rates combined with a widening of credit spreads. For green bonds, this difficult macroenvironment has resulted in historic negative returns; as at the end of June, the ICE BofAML Green Bond Hedged EUR returned -14.46%¹ . Nonetheless, there are reasons to be optimistic for both the short term and long term outlook for this burgeoning fixed income asset class.

A challenging backdrop

The inflationary context that the fixed income market has faced has been accentuated by the conflict in Ukraine. This has pushed central banks to radically change their monetary policy stance: the US central bank has already raised its key rates by 1.5% and the market expects another 1.7% increase by the end of the year. Meanwhile, the European Central Bank (ECB) has announced the end of its debt purchase programme and is expected to raise rates by 0.25% in July (the first time this has happened since 2011), while the market is expecting 1.30% by the end of the year.

In this context, at the end of June, the US and German 10-year yields both rose by 150bp respectively to 3.01% and 1.34%² . The rebound in rates has thus, in a few months, erased the rally observed over the last 5 to 10 years. Meanwhile, credit spreads, affected by the tightening of monetary policies and uncertainty about growth generated by inflationary pressures, have widened sharply.

Against this backdrop, the negative performance of the green bonds universe can be explained by the combination of the very strong rebound in interest rates and the wider credit spreads. Importantly, green bonds were more severely impacted than the conventional universe. This underperformance was mainly due to the difference in interest rate and credit sensitivity between the two universes.

Focus on green bonds’ tumult

At first glance, the difference in duration between the two universes is small. As the key characteristics table shows: 7.7 years for green bonds and 7.3 for conventional bonds.

However, part of the conventional universe is exposed to debts whose rates have remained relatively stable since the beginning of the year. The graph on the right demonstrates this with Japanese bonds, which contribute 1.3 years of the sensitivity, compared to the green universe which is mainly exposed to euro and US rates.

If we adjust for this bias, we can see that the green bond universe was much more exposed to the rebound in rates than the conventional universe. In addition, the green bond universe had a higher exposure to credit meaning they were more sensitive to the widening credit spreads seen this year.

Hence 2022 has provided the green bond market with the worst possible combination, resulting in a negative weighting, on relative returns, to conventional bonds.

Key characteristics 

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Top 3 duration contributors by currency 

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Sector breakdown 

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Source: AXA IM, Bloomberg, ICE BofAML indices at at 30/06/2022

Opportunities ahead

This inflationary environment is likely to continue to fuel high volatility in the fixed income markets, which are torn between inflationary pressures and the prospect of recession. We believe that the current volatility will provide opportunities for those able to cope with it in the short term, while longer term, the current valuations offer attractive prospects for investors.

Another reason for optimisim is the current yield level: at the end of June, the yield on the green universe was 50% higher than that of the conventional universe (1.78% vs. 1.39% hedged in Euro). Next to this, the average spread of the green universe is 70bp higher (in terms of OAS) than that of the conventional universe, the highest level ever observed (as shown on the graph). The composition of the green bond universe has not changed, so the higher spread reflects a stronger repricing for the green universe than the conventional one. We believe this repricing may provide opportunities and suggests that there might be light at the end of the tunnel for green bonds

It is also worth remembering that for many investors the green bond universe offers a balanced risk profile.  Half of it is made up of corporate issuers (compared to 25% in the traditional bond universe) so while this has meant more sensitivity to credit spreads recently, in the long term, it offers the benefits of better diversification away from sovereign-related debts and better expected returns.

Alongside that, the main ethos of green bonds is still the same: allowing issuers to identify specific environmental-friendly projects to which investors can explicitly allocate their capital. By doing so, green bonds provide investors with a unique level of transparency on the use of funds which is a real advantage over conventional bonds. It is worth bearing in mind that not all green bonds are the same and an active management approach should give investors access to green bonds where the sustainability assessment is based not only on the projects they finance, but also on the overall strategy of their issuers.

While it has been a challenging year so far, with a competitive yield, attractive valuations and the long term benefits of a well balanced universe and transparency, there are reasons to be optimistic for green bonds.

Green vs Global broad universe's spread 

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Source: AXA IM, Bloomberg, ICE BofAML indices at at 30/06/2022