Diversification is the primary challenge for portfolio management in the green bonds market, according to Fitch, with issuer numbers currently limited and clustered in only a few sectors.
In a 1 August opinion, the rating agency says that the total size of the investible green bond universe varies depending upon the specific definitions and characteristics of each fund.
However, it estimates, there are at present around 100 issuers – compared with the 3,000 found on broader indices.
“Many of these issuers,” it says, “are in a handful of sectors such as supranationals, utilities and local authorities, while sectors like banking and energy – which [form] a large part of the broader bond market – are currently under-represented.”
The limited number of issuers, Fitch notes, “creates concentration risk relative to other, broad market corporate bond funds, which can be exacerbated by the additional investment criteria imposed by most funds – or by a preference for bonds at a certain point on the credit-quality spectrum.
“Funds may choose not to invest in particular sectors, irrespective of whether a given bond is green.”
Nonetheless, some funds “mitigate this risk by being able to buy a certain proportion of non-green bonds from issuers that meet broader green criteria”.
Fitch points out that the green bond funds it reviewed while preparing its opinion also typically have greater exposure to credits in the BBB rating category, compared with green bond indices.
“This preference for low investment-grade credits,” it says, “is consistent with other corporate-bond funds and reflects a search for yield.
“But it also increases concentration risks, with only 22 BBB-category issuers in the Bank of America Merrill Lynch Green Bond Index.”
In Fitch’s assessment, investor appetite for the broad, sustainable-fund sector is “strong”, and it estimates that assets under management in green bond funds have grown more than 400% since the end of 2015.
However, it notes, the launch of a green bond ETF by Lyxor earlier this year could hamper the prospects of managed funds.
“The trend of passive funds cannibalising active funds has been clearly established in the broader market,” it says.
“In the green bond sector, limited diversification makes it harder for managed funds to differentiate themselves from the index – and the small size of the sector creates the risk of active funds being crowded out.”
With these risks in mind, the rating agency concludes, “2018 could be a pivotal year for the future development of the green bond fund sector, as several funds will achieve a three-year track record, which is the minimum required before many institutional investors will consider investing.”