Sovereign Green Bonds: Know the Risks and Rewards

Green bonds, popularly known as climate bonds, are fixed-interest financial instruments issued by any sovereign institution/inter-governmental organization/corporation. The proceeds of these bonds are used only for environmentally conscious, climate-resilient projects. In India, the framework for sovereign green bonds was released by the government late last year. It is worth noting that there is no limit on foreign investment in these bonds as these instruments are treated as specified securities under the fully accessible route.

Some foreign portfolio investors have a compulsion to invest in green bonds and will seek higher participation in these bonds going forward. Green bonds by design are issued at a premium and provide affordable capital for projects that support the environment. Hence, ‘greenium’ is the market term to describe the premium on green bonds. When a debt instrument is treated at a premium, the yield or return is lower, and the price is higher accordingly.

benefits: Since these bonds are issued by government entity / inter-governmental organization / corporations, they carry zero credit and default risk. This and the ‘greenness’ of these bonds explain the low yields that they come with. Also, as per the framework issued by the government, the investors in these bonds do not bear the project related risks. That is, the payment of principal and interest on the issues is not conditional on the performance of the projects.

Green bonds are a good investment vehicle for those who are more concerned with sustainable social development and greening of brown industries. For those interested in knowing how the money is invested, note that the government provides investors with the allocation of Sovereign Green Bond proceeds, as well as transparent reporting on the environmental impact of projects funded with the proceeds.

The allocation report will be updated annually until the proceeds of the outstanding Green Bonds are fully allocated. Retail investors can invest in Green Bonds through RBI’s Retail Direct website or through an account maintained with your broking house, if it is available.

In terms of taxation, no special tax benefits are provided for investment in Sovereign Green Bonds. The interest earned will be taxed at the slab rate of the individual. If the instrument is sold in the market before maturity, any increase in the bond value for at least one year will be taxed at 10%. Otherwise, short-term capital gains will be taxed at the applicable slab rate.

Associated Risks: In general, one of the most recognized risks in green bonds is ‘greenwashing’, meaning that environmental claims are made without evidence. In other words, the funded projects may not generate a net environmental benefit.

In addition, select large investors may hold green bonds until maturity (due to their investment mandate), which can lead to low liquidity and wide pricing differentials in the bond market. In some cases, the lack of liquidity also drives up trading costs.

India is at a nascent stage to assess whether there will be any greenwashing and if so, the degree of it and the liquidity position of these bonds. Environmentally conscious investors can invest only a portion of their money now and monitor the performance and reporting aspects of these instruments as it develops.

Investors need to know that although the terminology used sounds fancy, it may not suit everyone’s investment needs. Before investing in such bonds, investors should assess their investment goals, risk appetite, their existing portfolio etc. to take a decision. Of course, it may take some more time for the green bond market to mature and recover.

P Saravanan is Professor of Finance and Accounting and A Paul Williams is a Research Fellow at IIM Tiruchirappalli