Passive funds and concentration risk pose threats to the development of actively managed green bond funds, according to Fitch Ratings.

The credit rating agency highlighted the challenges ahead of what it said could be a pivotal year for the green bond sector in 2018. Next year will see a number of funds launched in 2015 reach a three-year track record, an important milestone for many fund selectors.

Although green bond issuance increased “dramatically” last year, the market was still small and there were a limited number of issuers, Fitch said.

It estimated there were around 100 issuers of green bonds, compared with 3,000 issuers in broader market indices.

“Many of these [green bond] issuers are in a handful of sectors, such as supranationals, utilities and local authorities, while sectors like banking and energy, which represent a large part of the broader bond market, are currently under-represented,” Fitch said.

The investable universe could end up being even smaller if funds applied additional exclusion criteria, thereby increasing concentration risks, the rating agency added.

It cited the example of a green bond issued by Repsol, a Spanish oil and gas company, in May, which was shunned by some investors due to concerns about the compatibility between the company’s business and environmental goals.

Fitch said some funds mitigated concentration risk by buying a certain proportion of non-green bonds from issuers that meet broader green criteria.

Fitch also raised the prospect of passive funds “cannibalising” active products, as has happened in broader markets. It highlighted Lyxor’s launch of a green bond exchange-traded fund earlier this year as potentially “hamper[ing] the prospects for managed funds”.

“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,” it said.

Chris Wrigley, senior fixed income portfolio manager at Mirova, said that although the green bond market was young and still growing, the asset manager had not encountered any particular diversification restraints.

“Green bonds are now diversified by currency, country, sub class, credit rating, maturity, sector, etc.,” he said. “We believe there are more than 165 issues in the Bloomberg Barclays Green Index and so there is a significant universe for portfolio managers to select from.”

Active managers can engage with issuers while passive managers will tend to wait for an index provider to remove a bond issue from an index if there are concerns from an ESG perspective, he noted. 

Fitch counted 17 dedicated green bond funds to date in Europe and estimated sector-wide assets under management of around €1.4bn as at the end of June, up more than 400% since 2015.

Continued growth in assets could also prove crucial to the sector’s success, Fitch added, as many institutional investors set minimum levels before they can invest in a fund and also typically cap their maximum percentage holding of any given fund. Five of the 17 green bond funds had assets in excess of €100m as at the end of June, with €100m being a common minimum hurdle for larger fund investors.

Although strong investor appetite for green bonds – combined with technical factors – could support the growth of the green bond fund sector, its prospects were “far from certain”, the credit rating agency said.

For example, green bond funds could simply be subsumed into ESG-integration bond funds, while limited issuance could also curtail sector growth.

However, Fitch also emphasised that “all fund sectors have to start somewhere and there are plenty of examples of specialist fund sectors developing over time”.

“In this case, broad institutional investor support is an important factor both within green bond funds and in direct green bond mandate-based investment,” said Fitch.

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