But it's not yet known if these new issues will be one-off concept bonds or if they will have legs

By Andrew Allentuck | October 2014

GREEN BONDS, A NEW CLASS of debt issued to fund environmentally friendly and socially responsible projects, have arrived in Canada. These new green bonds are designed to appeal to investors who want to do something for the environment or other good causes and also get paid for their efforts.

To date, the few Canadian green bonds have been issued by marquee names with no credit problems; the issues thus far have been senior notes of senior issuers with no credit risk greater than that of other senior debt. In contrast, some U.S. green bonds are downright scary.

The Canadian green issues, says Matthew Kolodzie, analyst with RBC Dominion Securities Inc. in Toronto, rank equally with others in capital structure.

For example, in January, Export Development Canada (EDC) issued a US$300-million, three-year bond, rated AAA, to fund projects to protect air, water and soil and mitigate climate change. That bond's yield to maturity, at 0.875%, was 11 basis points (bps) over U.S. treasuries at the time of issue.

On March 28, Toronto-Dominion Bank issued a $500-million offering of green-label senior deposit notes due on April 3, 2017, with an AA rating, priced to yield 1.824% at maturity. A news release accompanying that issue stated: "The bank will now be able to offer investors a vehicle that supports environmental mandates while providing a market rate of return. The concept is that the money will go to support green initiatives."

In July, a $231.5-million British Columbia green issue to finance a hospital's construction was a public/private partnership issue with a 32-year term maturing in 2046. That bond is rated A- and has a 4.394% coupon (169 bps over Government of Canada issues of similar term) with a yield to maturity of 2.7%.

There is a sales strategy behind green bonds, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto: "They appeal to people's ethical beliefs and view of the world. The concept and the market for green bonds provide an incentive for companies to do socially benevolent things."

Starting with a World Bank issue in 2008, green bonds have focused on funding responsible projects in waste management, hospital construction, water management, renewable energy, biofuels, public transportation, sustainable agriculture and recycling. EDC, for its part, has used green-bond capital for a renewable energy project in Argentina - a loan that the country, which has yet to pay off all of its massive 2001 default, might not have been able to get on its own.

Yet, the green concept is ambiguous. "It is in the definition of 'green'," says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. "There is no clear meaning of the word."

Take the U.S. green issues, for example. In January 2014, the Commonwealth of Massachusetts issued a green bond called the Juvenile Justice Pay for Success Initiative. That US$9-million issue - and companion issues from Bank of America in negotiation at time of writing - are designed to provide funds to deter young criminals from committing more crimes.

Each person the program keeps out of jail for a year saves Massachusetts US$12,500 a year, according to a Bloomberg LP report. The state would win, social service agencies would win and the deterred criminals presumably would win. It's all good economics designed to capture and monetize external matters, but there's a critical flaw in the plan: those who are to be deterred have no direct interest in paying the bondholders.

It's early in the life of these bonds and, so far, there have been no defaults. But bonds with an iffy payment mechanism need justification beyond yield to maturity.

These "stay out of jail" bonds were priced with huge payoffs if they work - and, of course, big losses if they don't. In August 2012, the State of New York issued a US$9.6-million "social impact bond" designed to reduce recidivism. The investor, Goldman Sachs Group Inc. in this case, will receive US$9.6 million. But if recidivism were to drop by more than 10%, Goldman would get a payoff of up to US$2.1 million. If recidivism does not drop by at least that much, Goldman could lose as much as US$2.4 million.

The balance point is a change of plus or minus 10% in the recidivism rate of a defined set of convicted felons. "The risk is great," says James Hymas, president Hymas Investment Management Inc. in Toronto. "And this is really equity in bond clothing."

Bond portfolio managers are leery of these U.S. green bonds. Says Barry Allan, president and CEO of Marret Investment Management Inc. in Toronto: "These U.S. socially responsible bonds are beyond credit analysis. They are unlikely to become a material part of the fixed-income market."

But Canadian green bonds, which thus far appear to be financially viable, should do as well as other bonds that do not have the "green" label. If, however, Canadian green bonds morph into U.S.-style, risky, concept bonds with questionable fixed-income characteristics, they're likely to have short lives.

There have been many concept bonds issued in the past; most were one-off tryouts. Yet, the book is open on green bonds. If the yield is sufficient and the terms of payment solid, this concept may succeed.

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