The market for “green bonds” is enjoying strong growth and investor demand is high, but a lack of diversification presents a challenge for fund managers who aim to develop investible products in that sector, according to Fitch Ratings Inc.

In a new report, Fitch says that investor appetite for green bond funds is high and estimates that assets under management (AUM) in green bond funds have grown by more than 400% since the end of 2015. But a scarcity of issuers in that space and the concentration of issuers in a handful of sectors represent a potential obstacle for fund managers, the credit-rating agency states.

So far, there are only approximately 100 issuers of green bonds, the report states, and they are limited to a few sectors such as utilities and local authorities. Sectors such as banking and energy, which represent a large part of the broader bond market, are currently underrepresented in the green bond market.

“The limited number of issuers 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,” the report states.

Fitch reports that the green bond funds that it has reviewed typically have greater exposure to issues in the BBB rating category compared with green bond indices.

“This preference for low investment-grade credits is consistent with other corporate bond funds and reflects a search for yield. But it also increases concentration risks,” Fitch states in its report. It adds that the lack of diversification in the universe of green bonds “will make it harder for active managers to differentiate their funds from each other and increases the threat from passive index trackers.”

Fitch says that the launch of a green bond ETF earlier this year could hurt the prospects for actively managed funds: “The trend of passive funds cannibalizing active funds has been clearly established in the broader market; 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 report adds, “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.”

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