How Do Green Bonds Work? - SmartReads by SmartAsset (2024)

Green bonds may appeal to investors who want to make a positive impact with their portfolios. These bonds are issued for the purpose of funding projects that support sustainability. The first green bond was issued in 2007 by the European Investment Bank, followed by the World Bank Green Bond in 2008. Since then, the market for green bonds has expanded steadily to include corporations and government entities. Green bonds can offer a number of benefits to investors who want to take an environmentally friendly approach to the market. A financial advisor can help you find securities that are environmentally suitable and also a good fit for your goals, timeline and risk profile.

Green Bond Definition

A bond is a form of debt, in which an issuer borrows money from a group of investors. In return, the bond issuer pays those investors their money back with interest. Green bonds are bonds that are focused specifically on sustainability and are used to fund green projects.

Green bonds may be issued by corporations, government agencies and global organizations. The money raised through green bonds may be used for a variety of purposes, including:

A green bond can also be referred to as a climate bond, as these bonds are intended to help improve environmental conditions or reduce negative impacts from climate change. Green bonds can be assigned credit ratings, just like other traditional bond offerings. But there are some things that distinguish them from other bond offerings.

For instance, green bonds may offer tax incentives that other bonds don’t. These can include tax exemptions and credits. Green bonds may also need to have their green status verified or certified by a third-party organization.

The market for green bonds has grown exponentially since the first green bond was introduced more than a decade ago. According to Moody’s, sustainable bonds are projected to account for 8% to 10% of total bond issuance for 2021. The green and sustainable bond market is projected to surpass $650 billion in 2021, fueled largely by demand among investors for climate-friendly investments.

Benefits of Green Bond Investing

Green bonds can appeal to investors on two levels. First, you may choose to go green with bonds if you’re hoping to build a sustainable portfolio. If you already hold mutual funds, exchange-traded funds or stocks from companies that support environmental, social and governance (ESG) principles, then green bonds could be a nice complement to those investments.

The money that’s raised through green bonds can be applied in a number of ways to support green practices. For example, the World Bank Green Bond raises money from investors to fund projects that seek to mitigate climate change or help people who are affected by climate change to better adapt to it. This includes funding disaster management programs, reforestation projects and clean transportation systems in areas around the world.

Green bonds can also be attractive in terms of taxation and income. Income generated by these bonds is typically tax-exempt and they tend to carry a lower risk for default compared to other bonds. So you can do good with your investment portfolio by supporting companies or government entities that fund green projects. And at the same time, you can earn reliable income on a tax-advantaged basis.

Are Green Bonds a Good Investment?

The green bond market is still relatively new but it continues to grow year over year. So, does that mean you should focus on green bonds issued by corporations and forego traditional bond investments?

Not necessarily. While green bonds can help diversify a portfolio and promote sustainability, there are some things to keep in mind.

First, not all green bonds are created equally in terms of their credit rating. So while they may be more favorable than junk bonds, they don’t always receive the same credit rating as traditional bonds. World Bank green bonds have a triple-A credit rating, for instance, while other green bonds may only earn a BBB rating.

Next, the current green bond market leans more toward corporate and supranational bonds, versus government bonds. Though if more governments take an interest in green bond issuance, that could shift, offering more opportunities for investors to choose high credit quality bonds.

Something else to consider is how green some green bonds really are. Unless a bond has been certified as green by an entity like the Climate Bonds Standard Board, then a green label may be just that – a label. For that reason, it’s important to take time to research green bond offerings to fully understand what the money being raised will be used for.

How to Invest in Green Bonds

If you’re interested in green bond investing, you can purchase them through an online brokerage account the same way you would any other bond offering. So you’d just need to choose a brokerage, create an account and deposit the minimum investment required to get started.The next step is choosing which bonds to invest in. Again, it’s important to research green bonds to understand:

Also, consider whether you’re interested in individual green bonds or a green bond fund. Green bond exchange-traded funds (ETFs) can offer exposure to a variety of green bond investments in a single basket. For example, the iShares Global Green Bond ETF tracks the performance of an index compared of global investment-grade green bonds. The goal of this green bond ETF is to produce returns similar to that of its benchmark while mitigating exposure to currency fluctuations.

If you’re interested in green bond funds or ETFs, check the fund’s underlying makeup so you understand what it holds. That’s particularly important if you’re investing in multiple green bonds. If you’re choosing funds that have similar holdings that could increase risk, rather than spread it around. Also, compare the expense ratios to understand what you’ll pay to hold a green bond fund or ETF on a yearly basis.

Bottom Line

Green bonds may only grow in popularity as more investors seek to mitigate some of the impacts of climate change with their portfolios. Understanding how these bonds work and what they fund can help you decide if they’re a good fit for you. It’s also important to look at the overall makeup of your portfolio to ensure that you’re balancing asset allocation to minimize risk.

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