Passive investment in green bonds ‘is a mistake’

Insight Investment questions value of passive green bond funds due to widespread quality issues in the market.

Insight Investment has warned that passive investment in green bonds is “a mistake” due to widespread quality issues in the market.

Simon Cooke, a portfolio manager in Insight’s emerging markets team, said that impact-washing was still present in the market. The manager rejects a quarter of labelled bonds as being not sustainable.

“There is a need for active assessment by the investment manager to actually look at the underlying bond and be able to determine whether it truly is achieving green or social benefits,” Cooke said. “If you just allocate passively, 25 percent of what you buy is probably not going to be generating any impact. That’s why we say passive is a mistake.”

Insight has not been the only firm to raise concerns around the quality of green bonds. NN IP’s Isobel Edwards told Bloomberg that the firm rejects 30 percent of green bonds for its active strategies, while PGIM’s fixed income unit revealed to RI it ranks half of all labelled bonds as “low impact”.

While active managers dominate the dedicated green bond fund space, passive funds are growing in both number and popularity. BlackRock’s iShares has a number of green bond ETFs, as does Amundi subsidiary Lyxor and DWS’s Xtrackers.

The criteria for a green bond to be included in a passive index varies. The Solactive indexes tracked by Lyxor’s ETFs include green bonds based on data from the Climate Bonds Initiative, whereas to qualify for the widely tracked Bloomberg MSCI green bond index, a bond must pass basic criteria from MSCI’s ESG research team on use and management of proceeds, project selection and performance reporting.

A spokesperson for BlackRock said that MSCI sets a rigorous standard for inclusion in its index and that bonds are removed from the index if they fail to meet reporting standards. MSCI also engages with issuers regularly and bonds will only enter the index once all requested details have been received. The index provides transparency, standardisation and access to a diversified portfolio of bonds, the spokesperson added, and BlackRock itself produces an impact report for investors.

Yelling over yellow

Insight previously used a traffic light system to classify labelled debt, with bonds in the green and yellow categories considered for investment. However, it switched to a system of dark green, light green and red after clients questioned why the manager was investing in “yellow” bonds.

Among the sustainability areas considered by the firm are use of proceeds, whether the bond is for financing or refinancing, any associated sustainability targets, how progress is monitored and reported, and whether a second-party opinion is present.

“It’s important we can be certain where the proceeds are going and it’s additional,” said Cooke. “Can we with confidence say the capital is going to deliver an environmental and/or social impact and can we demonstrate that through some reporting of a KPI over time?”

He added that the firm might invest in a green bond from a coal utility which was looking to finance renewables expansion, as the direct replacement of coal would have “a massively positive impact”, but would look askance at an oil and gas company looking to retrofit its headquarters.

In the emerging markets space, Insight sees quality improving rapidly. Two years ago, the firm was rating half of all EM green bonds as red, but this has fallen to 25 percent, in line with developed markets.

Greenwashing is still a force in the market, Cooke said. “When it used to be 50 percent failing, it was just companies not knowing the standards. I think we are now seeing certain issuers who are not necessarily deliberately misleading but kind of pushing the boundaries of what should be considered green.”

Greenwashing is a risk for both issuers and managers because there’s “an insatiable demand for people to stick labelled stuff in their funds”, he continued.

“I’d be glad for some others like ourselves to take a more stringent approach and ask whether they can demonstrate impact because ultimately [impact is] what we’re selling to clients, and we don’t want to sell clients a load of nonsense.”