               TheSterlingBondMarkets and LowCarbonorGreenBonds AreporttoE3G  AlexVeys   May2010 1  Abouttheauthor Alexhasover20yearsexperienceinthebondmarkets,workingforbrokers,asaquantitativeanalyst for10years,andforFidelityInvestmentsasaportfoliomanagerwherehemanagedalltypesof bondfund.HealsochairedtheiBoxxoversitecommitteeforseveralyears.Hehasadeepknowledge ofbonds,derivatives,investorsandbor rowers.AlexleftFidelityin2007tocompleteaMastersin SustainableEnergyatImperialCollege,London.Afteradvisingandworkingwithseveralcompanies in2009,hehastakenuptheroleofChiefInvestmentOfficeratPartnershipAssurance. 2   1. ExecutiveSummary  1.1. TheUKBondmarketissmallcomparedtoglobalbondmarketsandbiasedtolongerdated,  andthereforeriskier,bonds.  1.2. TheUKBondmarketisvaluedatabout£1.2trillionwith£700billionofthismadeupofUK governmentgilts.  1.3. Theinsuranceandpensionindustriesholdacom binedvalueof£850billionofbondassets (notallintheSterlingbondmarkets)andareclearlydominantbuyers.  1.4. AbouthalfthenumberofbondsintheSterlingmarketareissuedbyUKorganizations, makingupabout75%ofitsmarketvalue.  1.5. Twoofthebiggestobstructionstopen sionfundsinvestinginclimaterelatedinvestments aretheirdeficitsandobscurecaselawdatingfroma1970smineworkersdispute.  1.6. Thereisonlyashorthistoryofgreenorclimaterelatedbonds.Thesewereinitiallyfocused oncomplexproducts,scandinavianclientsortax‐driveninstruments.  1.7. Tremendousstructuraleff ortsareneededtoincentivizepensionfundsandinsurance companiestopurchaseclimaterelatedbonds.  1.8. IncentivessuchasguaranteesorinsurancefromtheUKgovernmentoranewGreen InvestmentBankarelikelytoefficientlyleveragepublicmoney.  1.9. Taxincentives,likethoseofferedintheUSMunicipalbondmarket(10%ofthetot alUSbond market)couldbesuccessful.Thiswillleadretailinvestorsintothemarket,thoughthiswill notraisethevolumesofcapitalneededwhichwillcomefromtheinstitutionalmarket  1.10. Greenorclimatebondswillneedtoreflectcurrentbondstructurestoaddressexisting demand .Newstructureswithoutfundamentaldemandfrommajorinvestorswillfail.  1.11. Thereisanurgentneedforaclimatebond“ratingagency”to“police” bon ds toensurethat fundsareusedforgreeninvestmentsandthatinsuranceandguaranteescanthereforebe reliablyoffered.  1.12. Welldesignedgreengilts,andaGreenIn vestmentBank,willshowthattheGovernmentis seriousandcommittedtotacklingclimatechangeaswellashelpingfinancelargeclimate relatedprojects,leveragingpublicmoneyandleadingworldanddomesticmarkets.   3     Contents Abouttheauthor 2 1. ExecutiveSummary 3 2. IntroductiontoBonds 6 2.1. History 6 2.2. RiskFeatures 6 2.3. LegalStatusandGrowthParticipation 7 2.4. CreditRatings 8 2.5. PrimaryandSecondaryMarkets 9 3. SterlingBondMarkets 11 3.1. GlobalContext 11 3.2. SterlingBonds 12 3.3. MarketSectors 12 3.3.1. DomesticBondsandBulldogs 12 3.3.2. EuroSterlingBonds 13 3.3.3. Glo balBonds 13 3.4. TypesofBonds 13 3.4.1. ConventionalBonds 13 3.4.2. IndexedBonds 13 3.4.3. AssetBackedandSecuritizedBonds 14 3.5. IssuersaretheSupply 14 3.5.1. Country,IndustryandRatingsBreakdown 14 3.5.2. Gilts 17 3.5.3. OtherKeyIssuers 17 3.5.4. BondIssuerSize 17 3.5.5. USMunicipalBonds 17 3.6. BrokersaretheGlue 18 3.7. EndInvestorsaretheDe mand 20 3.7.1. AssetsandLiabilities 21 3.7.2. PensionFundDeficits 22 3.7.3. ClimatechangeandPensionDecisions 22 4. GreenorLowCarbonBonds 24 4.1. History 24 4.1.1. WorldBankBonds 24 4  4.1.2. EIBBonds 25 4.1.3. USBonds 25 4.1.4. BreezeBonds 25 4.1.5. Overview 26 4.2. SourceofFunding 26 4.3. CharacteristicsandStructureofaGreenBondMarket 27 4.3.1. CarbonRatings 28 4.3.2. Incentives 28 4.3.3. GovernmentBonds 29 4.3.4. OtherAAARatedBonds 30 4.3.5. InvestmentGradeBonds 30 4.3.6. HighYieldBonds 31 4.3.7. WhatWillNotWork 31 4.4. Benefits 31 4.6 Movingforward 32 Appendix 33 A.1Glossary 33 A.2GiltEdgedMarketMakers(GEMMs) 34 A.3BondCalculations 35 A.3.1RunningorCurrentYield 35 A.3.2SimpleYield 35 A.3.3YieldtoMaturity 35 A.3.4OtherYieldCalculationMethods 36 A.3.5Duration 36 A.4TheYieldCurveanditsTheories 36 A.4.1Expectations 37 A.4.2Liquidityorriskaver sion 37 A.4.3Segmentation 37  5    2. IntroductiontoBonds  BondscanvariouslybedescribedasIOUs,loansordebts.Theyaresimilartobankloans, butgenerallylastlonger(from1yeartoover30years).Wheninstitutions,companies,govern ments andotherentitieswanttoraiselongtermfinancebutdonotwanttodilutetheirshareholdings(or, indeed,c annotissuesharecapital─liketheUKGovernment),theyturntothebondmarkets.Here theycanraisemoneywithouthavingtopayitbackforpossiblydecades.Ontheothersideofthe dealaretheinvestors.ThebiggestinvestorsintheUKaretheinsurancecompaniesandpensi on funds.Theybuybondstogeneratereturn,offsettheirliabilities,generateincomeordiversifytheir portfolios. 2.1. History  Beforeelectronicownershipofbondsbecamecommoninthelatterpartofthetwentieth century,whenaninstitutionissuedbonds,thelenderreceivedacertificate.Thiswasoftenavery elaborateandlargedocumentwithpicturesofwhateverthebondwasfinancing(trains,factories, airplanesetc).Amongstotherinformationitalsosho wedhowmuchthecertificatewasworth(i.e. howmuchhadbe enborrowed),therateofinterest,thecurrencyandtheborrower.  Atthebottomofthecertificatewereanumberof“coupons”attachedtothemainbodyby perforations(likestamps).Periodically,thelenderwouldgotothepayingagent 1 withthe certificate;thepayingagentwouldtearofftherelevantcouponandhandovertheinterestpayment. Atmaturity,thewholecertificatewouldbepresented,the“principal”(ornominalamount)ofthe loanandfinalcouponpaidandthecertificatecancelled.Westillusethisslightlyarchaic terminology 2 today,referringto“coupons”and“principal”eventhoughvirtuallyallbondsarenow heldelectronically. 2.2. RiskFeatures Whenaninvestorthinksaboutpurchasingabond,therearefourkeyriskattributesthatthey willassesstodeterminewhetherthebondisagoodfitwiththeirportfolio,howlikelyitisthatthe expectedreturnswillbeachieved andwhetherthepriceisfair.Theseattributesare:   itsissuer  itscurr ency  itscoupon  itsmaturity  Issuer−Theissuerofthebond(i.e.borrowerofthemoney)definesthecreditriskofthebond. Thatis,thelikelihoodthattheinvestorwillberepaidtheirinitialloan.Forexample,governmentsare generallyconsideredtohavealowcr editrisk(seesection2.4).  Currency−Akeydifferencebetweenequityanddebtisthat,unlikeequity,institutionscanissue bondsinmanycurrencies.Indeedbondmarketstalkaboutthecurrencyofissuanceandnotthe   1 Thecompanyemployedbytheborrowertofacilitatepaymentstobondsholders 2 Intheappendix,A1,thereisaglossaryofmanyoftheseterms. 6  countryofissuance.Forinst ance,Vodafone,withitsequitylistedinLondon,issuesdebtinsix currenciesincludingtheAustraliandollarandCzechKoruna.Thecurrencyofthebonddefinesthe secondkeyriskcharacteristicofthebond.  Coupon−Thecouponorinterestratedefinestherateofinterestpaidontheb ond.Thisinterest canbepaidannually,semi‐annuallyorevenevery3months,dependingonthewaythebondis structured.Thestatedrateofinterestrelatestotheoriginalamountofmoneylentorthe“face value”ofthebond 3 andismoreoftenthannotanotionalvalueof100or“par”.Thisisoftennotthe sameasthepricepaidforthebond. Thesizeofthecoupongivesanindicationofthecreditriskof thebond.Thehigherthecoupon,thegreatertheriskinessoftheis suerasaninvestorwillrequirea higherinterestratetocompensatethemforthegreaterlikelihoodoftheissuerdefaulting.  Maturity−Thematuritydateis thedatetheinvestorgetstheirmoneyback.Thereareanumber ofsubtletiesaroundthematuritydate,butmostbondshaveasinglefixeddate .Thefurtherinthe futurethematuritydate(the“longer”thebond),themoreriskythedebtasthereismoretimefor theissuertogetintotrouble.Indeed,somebonds(includingthefamouswarloanfromtheUK Government)are“undated”,whichmeansthattheissuerneverhastorepayth edebt.Undated,or perpetual,bondsoftenhavefeaturesthatallowtheissuertopaybackthedebtundercertain circumstances:thesearecalled“calloptions”andgivetheissuertheright,butnottheobligation,to paybackthelender 4 . 2.3. LegalStatusandGrowthParticipation Therearethreebroadwaysinwhichacompanyorinstitutioncanraisemoney:throughthe equitymarkets,thebanksorthebondmarkets.Eachofthesehastheirownmeritsasshownin Table1.  Intermsofle galstatusandgrowthparticipation,bankloansandbonds areverysimilar.The maintwodifferencesarethelengthoftheborrowingandwhatrightsthelenderhasifthecompany goesintobankruptcy.Banksloansareoftenmuchshorterinmaturitythanbondsandbanksusually gettheirmon eybackbeforebondholders.  Thekeydifferencesbetweenbondsandequityisthatmostequityhas votingrights and  participatesinthegrowthofthecompany(i.e.sharesintheupside),whereasdebthasneither votingrightsnortheabilitytoparticipateinthecompany’sgrowth.However,debtorsdohavethe abilitytocallintheadministratorsifthecompa nydefaultsonapaymentorbreaksacovenant 5 (and possiblyclosedownthecompany).Theyalsohaveanearliercallonthecompany’sassets.Soifthe companydoesdefault,thebondholdersoftengetsomethingbackwhilsttheequityholdersget nothing.Indeedinthisscenariothebondholdersusuallyendupowningthecompany.Inbond marketlangu agethismeansthatthedebtholdersrank“above”,are“higher”or“senior”tothe equityholders.   3 Aholdingof£1,000inabondwitha5%coupon,boughtat95stillpaysacouponof£50(5%*£1000) althoughtheeffectiveor“runningyield”willbe5%/0.95=5.26%as95ratherthan100waspaidforthebond. 4 TheUKWarLoanisundatedandhasa3.5%couponratethatispaidsemi‐annually(1.75%oftheface valueevery6months).However,since1952theTreasuryhasbeenableto“call”thebondandpay backinvestorsatapricegreaterthan100(orPar).Unfortunately,evendur ingthedeflationaryhiatus ofJanuary2006thepriceofthebondonlyrosetoabout94withayieldof3.7%sothebondwasnot called.Warloaninvestorsarethereforeveryunlikelytogettheirmoneyback(ever)! 5 Alegallybindingpromisemadebytheissuertotheinvestorintheprospectus. 7    Table1:Comparisonofequity,bondandbankloancharacteristics BROADCHARACTRISTICS Equity Bond BankLoan UsualTerm Perpetual MediumtoLong term Shortterm Participationingrowth Yes No No Regularpayment Variable Fixed Fixed Creditorranking Low High Highest Voting Yes No No Legalrecourse Companylaw Instigatebankruptcy Instigatebankruptcy       Greaterassetsecurity Greaterpote ntialriskandreturn 2.4. CreditRatings CreditRatingsarefundamentaltogoodbondfundmanagement.Notallbondshavearatingbut, thosethatdonot,sufferfornothavingone, havingtopaymoreforthemoneytheyborrow.  Therearethreemajorratingagencies,Moody’s,StandardandPoor’s(S&P)andFitch.Theyall havesimilarrat ingcategories,whichreflectthelikelihoodofabonddefaultingortherating changing.  Fromthecoarsestperspective,bondsareeitherinvestmentgradeorhighyield 6 .Thearbitrary bandbetweenthetwosectorswascreatedbyMoody’sintheearlypartofthetwentiethcenturybut hasremainedimportant−somefundscannotinvestinsub‐investmentgradebonds.  Thenextlevelsplitseachsectorintoratingsbands 7 asshowninTable2.Thisalsoshowsthe averagelevelofdefaultsforaparticularratingovera1yearand5yearhorizon.Thedatausedis fromthewholeoftheMoody’sdatasetgoingbackto1920(whichseemspertinentgivenwhatthe worldisgoingthroughatthemoment).Itisclearthatastherat ingsfallsodoesthelikelihoodofa defaultandalsothatthegreaterthetimehorizonthegreatertheprobabilityofdefault.Itisalso clearthatnobondwitharatingofAAAhasdefaultedovera1yearhorizon.Over5yearstherehave beenAAAdef aults,butthesebondswouldhavebeendowngradedtoothercategoriesoverthat5‐ yearperiod.    6 Highyieldcanalsobetermed“junk”,“speculative”,“non‐investment”or“sub‐investment”grade. 7 ThereareevenfinerspacingsthanshowninTable2,andthesecanbefoundontheagencieswebsites  8  Table2:Ratingagencycategoriesanddefaultrates S&Pand Fitch Moody's Oneyear avergedefault rate* Fiveyear  averagedefault rate* AAA Aaa 0.00% 0.16% AA Aa 0.07% 0.72% A A 0.09% 1.26% BBB Baa 0 .2 9% 3 .1 3% BB Ba 1.36% 9.90% B B 4.03% 22.42% CCC Caa CC Ca 14.28% 41.18% CC Defaulted D D 100% 100% Investme nt Grade HighYield *Source :"CorporateDefaultandRecoveryRates,1920‐2009" Moodys.Datausedfrom192 0to2009.  2.5. PrimaryandSecondaryMarkets  Thelifeofabondhastwophases,primaryandsecondary.Theprimaryphaseisthegestation periodofabondbeforeitispricedandlaunchedintothemarkets.Afteritsinitialpricing,itenters itssecondaryphase.  Theprimaryphaseencompassesalltheworkleadinguptothepri cingandlaunchingofabond. Thisincludes:   Creatingtheprospectus 8   Writingresearchtosupporttheissue  Talkingwithinvestorstoseeatwhatpricetheywouldbuythebond  Buildinga“book”(gatheringalistofinvestorswhohavecommittedtobuyingthebond)  Workingonsellingotherbondstofacilitatethepurchaseofthenewbond  Thefinalp ricing  Thereareoftenseveralbrokersworkingtogether(mainly!)ontheprimaryissuanceofabond. Thesearecalledleadandco‐leadmanagers.Havinganumberratherthanoneleadmanagergives thebondthegreatestpossibleexposuretopotentialbuyersaseachbrokerwillhavesomenon‐ overlappingclients.Theke yobjectiveforthebrokersistogetthebest(i.e.highest)priceforthe bondtoraisethemostamountofmoneyfortheclientwhilstalsoensuringthatallthebondsare sold.Indeed,itisgoodpracticetoensurethatthereismorede mandthansupply 9 .    8 Thisisadocumentpossiblyseveralhundredpageslongwrittenbylawyerstospecifyingreatdetailwhat rightsaninvestorhasandwhattheissuercandoandhastodowhilstthebondusstillinissuance(not matured) 9 Ifthebondispricedtoohighandtheentirebondisnotsoldtoendinvestors,thebondbecomes tarnishedandperformnotonlybadlytostartwith(i.e.thepricewillfall)butinthelongtermthebondmay alsonotperformwell(investorshavememories!).Thisimpactstheabilityoftheissuertosellmorebo ndsin thefuture. 9  Theprimaryphasefinisheswhenbond shavebeenallocatedbythebrokerstoclients,switches 10  outofotherbondscompletedandthepriceset.Thesecondaryphasethenstarts.  Whenabondentersitssecondaryphaseitisopentobetradedbyall.Generally,thebrokers,or leadmanagers,thatbroughtthebondtomarketcommittomakingatwowayprice 11 inthebondfor itslife.Inreality,thisisnotalwaysthecaseespeciallyindifficultmarketconditionswherethereisa lotofvolatility 12 orifthebondisofasmallsizeand/orhasacomplexstructure(toomanybellsand whistles 13 ).Thisisimportantasitimpactstheliquidityofthebond,itspriceandthewillingnessof investorstoownit 14 .     10 Abrokeragreestobuyanexistingsecondarymarketbondinexchangeforsaleofthenewprimary marketbondonfixedterms. 11 Theycommittobothofferingtobuyorsellthebondor“makeamarket” 12 Volatilitycanbecausedbyarangeoffactorsincludingforexampleemergingeconomicdata,loans crises,politicalunrestanddefaults. 13 ‘Bellsandwhistles’couldincludecalloptions,putoptions,oddcouponpaymentsallofwhichcanbe complextounderstandandcanthereforebeadisincentivetoownership.Demandforthesetypesofbonds tendstobelower,becauseofthesetime,costanddemandoverheads. 14 Liquidityisessential,asitallowsthefundmanagertochangethestructureoftheirportfoliointhe eventofdifficultmarketconditions. 10  [...]... because of its flexibility (the markets are above country markets and regulation and therefore lack  national barriers to entry and are subject to less political risk), the Euromarkets, and in the UK’s case  the EuroSterling market, continue to grow and be the market of choice for issuance.    3.3.3 Global Bonds  Global bonds are simply bonds issued in the Euromarkets and domestic market at the same  time. This allows investors who cannot engage in one of these markets to still be able to buy the ... bonds and conventional corporate bonds (either in the domestic or euro market), which are mainly  owned by pension funds and insurance companies, most Muni bonds are owned by the retail sector.     Muni bonds are issued by local and state governments (Municipalities). They are used to finance  municipal projects such as roads, sewers and bridges etc and are generally secured on either the full  “faith and credit” of the issuer (e.g. the State) or on the revenues from the project that is being ...   The sovereign sector is clearly the largest sector and only includes only gilts.     The quasi and foreign government sector (10.3%) is dominated by the EIB (3.5%) and KfW  Bankengruppe (2.5%). The former is a supra‐national agency rated AAA and the latter a German  government agency also rated AAA.    The financial sector (predominantly banks and insurance companies) is more broadly spread but ... incentives (eg ISAs).    Pension funds and Life Insurance companies have long term time frames with liabilities  averaging over 20 years and more. Their investing is naturally driven into equities and long term  bonds which fits well with climate related projects. It is therefore likely that insurance companies  and pension funds will be the largest investors in climate related companies and projects.     The aggregate amount of long term assets held in UK Pension funds and insurance companies ... Finding investors to buy green bonds is crucial − and the key to finding these investors is to seek  out large repositories of money and understand their portfolio needs.  The largest single  concentrations of money are in the hands of institutions such as insurance companies and pension  funds.  Such institutions will be looking for Iong‐dated bonds − and premium is likely to be needed to  encourage early uptake when the market is less liquid. Beyond this, for Government to incentivize ... billion of gilts in the market contributing to about 60% of the UK bond market. Over the last few  months the size of the non‐gilt market has fallen, mainly due to significant maturing bonds, slower  growth and deleveraging.    Figure 2: Total value of the UK bond market end February 2010  Sizes and proportions of UK Gilt and EuroSterling Market and proportions 100% 800  90% 700  80% 600  Billions of GBP 70% 500  60% 400  50% 40% 300  30% 200  20% 100  10% ‐ 0% 1986 1988 1990... (Property Assessed Clean Energy bonds). These PACE bonds are, and will be, used to finance energy  efficiency and renewable energy improvements in buildings. The particular innovation that makes  this financing popular and widely available, is that the security for the repayment of the loans  underlying the bonds 35  lies with the property and not with the owner of the property. Hence, when  the property is sold, the liability to repay the loan is transferred to the new owner of the house. In ... also have to maintain a reasonable market share − meaning that they have to actually buy and sell  bonds (rather than just making markets and not transacting) in both the primary gilt auctions and  the secondary markets. As a benefit, they are the only market participants that can buy gilts directly                                                               36  A book is a trader’s portfolio of bonds. This will be made up of both real bonds and derivatives.   See section A.4. ...  A list of the current GEMMs is in Appendix A.2.  39  The gilt issuing arm of the UK Treasury.  37 19    from the DMO and are able to “strip” and  reconstitute” gilts 40  They are also invited to a quarterly  DMO meeting to discuss future issuance and offer their advice to the DMO.    The DMO has two sets of meetings each quarter: one for investors and one for GEMMs, both of  which follow the same form. The DMO first presents their view of the market, their expectations on ... which follow the same form. The DMO first presents their view of the market, their expectations on  future issuance over the following quarter in the context of the financial year, and any other  pertinent detail. The floor is then given to the investors or GEMMs, who have  their chance to air  their views on issuance, maturities and asset mix (conventional and index linked). Investors and  GEMMs can also make other relevant points. These are key meeting at which the DMO learns about