The Fisc

When you’re an issuer, it’s really hard to measure the effectiveness of the myriad decisions you have to make in managing your bond programs. For example, when I was an issuer, I struggled to measure if I made the right decision to advance refund bonds. Did I time it right or did I waste the option by pulling the trigger too early? On a pre-sale basis, I’d also often wrestle with bond structuring decisions, such as couponing. Should I have pushed for a lower coupon on that bond? Or, should I have stuck with a 10-year par call option, or instead tried for shorter calls?

Literally scores of decisions that could greatly impact how your bonds price in the market, and consequently the cash flows required to repay the bonds over two or three decades, and yet there was virtually no mechanism to isolate the cost/benefit of a single decision. I think the lack of market signals on these decisions is probably why a lot of issuers follow the status quo when issuing bonds. The default option seems to be plain vanilla fixed-rate bonds with 5% coupons and a 10-year par call.

All of these questions fall into a catch-all of “Can I get paid for making better decisions?” I’ve written in The Bond Buyer and previously in The Fisc about issuers getting “paid” by investors for having better disclosure and transparency. To put it more succinctly, the question comes down to “Will the bonds I’m responsible for issuing price better based on the decisions I make in the structuring phase of the financing?” It’s an incredibly important question for all public sector debt managers to ask themselves.

Some new and exciting research provides very positive market signals for issuers thinking about issuing Green Bonds. Researchers Malcolm Baker, Dan Bergstresser, George Serafeim and Jeffrey Wurgler released a draft of their white paper, “Financing the Response to Climate Change: The Pricing and Ownership of U.S. Green Bonds” at the recent 2018 Brookings Municipal Finance Conference last month. You can read it here.

The research paper provides an overview of the U.S. municipal bond market covering 2,083 Green Bonds issued between 2010 and 2016. The issuance of bonds identified as “green” rose from less than $500 million a year in 2010 to over $2 billion in 2014, totaling $6.5 billion in 2016. The authors point out that most of the bonds are self-labeled as “green” by issuers due to a lack of a standard set of definitions in the muni market, and the bonds’ purposes include a wide variety of projects that were intended to be environmentally beneficial.

The results of their analysis are very powerful: Green Bonds are issued at a premium to otherwise ordinary bonds – that is, with lower yields on an after-tax basis. They estimate the pricing advantage at six basis points, or an amount equal to about half of a bond credit rating notch, according to their study. To quantify this using some very conservative estimates, on a $100 million bond sale with level debt service over a 30-year maturity, the present value of a reduction in the True Interest Cost (or TIC) of six basis points is worth nearly $1 million to an issuer. That’s real money. Further, Green Bonds that are certified by a third party like the Climate Bonds Initiative price at an even higher premium.

The “why” to this pricing advantage flows into a second meaningful benefit that should get the attention of issuers looking to diversify and grow their investor base: Green Bonds ownership tends to be concentrated with investors who are not just seeking yield, but also seek to invest with some measure of social responsibility. To quote the authors: “A subset of investors appears willing to sacrifice some return to hold green bonds, particularly ‘certified’ green bonds. Green bonds are held disproportionately by these investors.” To put it another way, if you issue Green Bonds there is a good chance your bonds find their way to new investors. That diversification is very valuable over the long-term.

This is critically important research given how fast the Green Bonds corner of #muniland continues to grow. And it’s exactly the type of research that could drive capital budgeting decisions all over the country. Investors are sending signals to governments that they value the opportunity to invest in environmentally beneficial projects. Issuers should recognize those signals and adjust accordingly, but so should the policy makers like the governors and mayors who determine which projects receive capital funding.