The Sterling Bond Markets and Low Carbon or Green Bonds - A report to E3G ppt

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TheSterlingBondMarkets
and
LowCarbonorGreenBonds
AreporttoE3G
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AlexVeys
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May2010
1
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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.
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1. ExecutiveSummary
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1.1. TheUKBondmarketissmallcomparedtoglobalbondmarketsandbiasedtolongerdated, 
andthereforeriskier,bonds.
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1.2. TheUKBondmarketisvaluedatabout£1.2trillionwith£700billionofthismadeupofUK
governmentgilts.
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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.
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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.
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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.
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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.
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1.7. Tremendousstructuraleff
ortsareneededtoincentivizepensionfundsandinsurance

companiestopurchaseclimaterelatedbonds.
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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.
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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
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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.
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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.
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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.
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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
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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
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2. IntroductiontoBonds
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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.
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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
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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
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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).

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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


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Thecompanyemployedbytheborrowertofacilitatepaymentstobondsholders
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Intheappendix,A1,thereisaglossaryofmanyoftheseterms.
6
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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
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.
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

3. SterlingBondMarkets

3.1. GlobalContext

TheMerrillLynchGlobal BroadMarketIndex
15
wasvaluedataboutUSD36trillioninthemiddle
ofMarch2010andincludesallinternational,investmentgradebonds.TheSterlingportionofthis
marketisrelativelysmallasshowninFigure1 withon
lyabout5%ofthetotalmarket.Nevertheless,
itisthefourthlargestbondmarketintheworldandwasthethirdbeforetheadventoftheEuro
(biggerthantheEuroDEMmarket).

Aninterestingcharacteristicofthemarketisthatithasaverylong“duration”(ameasureofthe
averagetim
etomaturityofthemarket).Thisgivesanindicationofwheremostbondsareissued
andalsotheriskinessofthemarketorhowthepricemoveswithinterestrates
16
.Indeed,ifthis
interestrateriskinessistakenintoaccount,theGBPmarketcontributestoabout7.5%ofthetotal

globalinterestrateriskcomparedto5%oftheglobalmarketvalue.Thisisimportantasitshowsthat
theUKbondmarkethasastrongdesireforlongertermbon
dswhichislikelytobefromwherethe
supplyofgreenbondscomes
17
.

Figure1:MerrillLynchGlobalBroadMarketIndex
Index
Weight
Average
Duration
(%) (years)
USD 43.7 4.5
EUR 27.8 5.4
JPY 17.9 6.7
GBP 4.9 8.1
CAD 2.9 6.4
AUD 1.0 3.8
KRW 0.7 4.3
PLN 0.3 4.0
DKK 0.3 7.3
OT HR 0.3 5.1
CHF 0.2 6.9
SEK 0.2 6.0
Currency





15
Therearemanyindexproviders,buttheMerrillLynchseriesofindicesisofhighqualityandreadily
available.
16
Thechangeinthepriceofabondmovesintheoppositedirectiontothechangeinitsyield:iftheyield
movesup,thepricemovesdown.Allotherthingsbeingequal,thelongerthetimetomaturityofthebondor
thelongerthe“duration”ofabond,thegre
aterthemovementinthepriceofthebondforagivenchangein
yield.Hence,ifthemarkethas,inaggregate,gota“longerduration”,itismorerisky.
17
ItalsoindicatesthatinthepastfewdecadestheUKhasbeenregardedasverycredit‐worthy,duetoits
prudentfiscalmanagementsincethe1970scrises.
11


3.2. SterlingBonds

ThetotalmarketvalueoftheUKbondmarketattheendofFebruary,accordingtotheMerrillLynch
BroadMarketindex,was£1.2trillion.Figure2showshowtheUKbon
dmarkethasgrownand
developedoverthelastquarterofacentury.ItdoesnotshowtheUKhighyieldsector(bondsthat
arenotratedas“investmentgrade”
18
)asthisisatinyproportionoftheUKmarketworth,only
about£22billion.

Uptothemid1990stherewasno“non‐gilt”markettospeakof,withmorethan90%ofthemarket
beingcomposedofissuancefromHerMajesty’sTreasury.Fromthemid1990s,thesizeofthenon‐
giltmarketgr
ewsteadilywhilstthegiltmarketonlygrewinfitsandstarts

19
.Byearly2008,thegilt
marketwasonlyabout40%oftheoverallUKBondmarket.Since that timehowever,giltissuance
hasacceleratedasaresultofthegovernmentbailoutoftheUKbanks.Nowthereareover£700
billionofgiltsinthemarketcontributingtoabout60%ofth
e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
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
‐
100
200
300
400
500
600
700
800

1986 1988 1990 1992 1994 1996 1998 2000 2002 200 4 2006 2008 2010
BillionsofGBP
Size sandproportionsofUKGiltandEuroSterlingMarketandproportions
Giltmarketasa perce ntageoftotal market (RHS) EuroSterlingMarket(LHS) GiltMarket(L HS)


3.3. MarketSectors
Bondscanbeissuedeitherinthedomestic,euroorglobalmarkets.
3.3.1. DomesticBondsandBulldogs




18
Seesection2.4.
19
Thenon‐giltmarketgrowthwasdrivenbygrowthintheUKeconomyanddisintermediationofthe
banks;giltmarketgrowthwasdrivenbyborrowingaroundtheeconomiccycle.
12

Bondsissuesintodom
esticmarketsareissuedundertherelevantdomesticlaw.Forinstance,
GiltsareissuedintheUK’sdomesticmarketunderthejurisdictionoftheUKregulatorsandlistedon
UKstockexchanges.AforeigncompanycanalsoissuedebtintheUK’smarketwithitsbondsbeing
called“bulldogs”(similarlythereare“Yankeebonds”intheUSand“Samuris”inJapan).

Apartfromthe,clearly,veryimportantgiltmarket,thedomesticandbulldogmarketiscurrently
verysmallandnotimportantintheUK.IndeedthereareonlyabouttendomesticbondslistedinUK
BondIndicesbondsmaki
nguponly0.3%oftheoverallmarket.However,thismaybecomealarger

sectoriflocalauthoritiesstarttoissue(climaterelated)bondsinthedomesticmarket.Thiswouldbe
especiallytrueifthereweresomeformoftaxincentiveforlocalauthoritybonds(seesection3.5.5
onMu
ni s)Bond
3.3.2. EuroSterlingBonds
ThisisbyfarthelargestsectorintheUKnon‐giltbondmarketcoveringover99%ofnon‐gilt
bonds.TheEuromarketsgrewupinthe1960sasaresultofcomplexinternationaltaxagreements.
Broadly,aEurobond,andspecificallyaEuroSterlingbond,isabondthatisnotissuedundera
particularjurisdictionbu
t,inthecaseofaeuro‐sterlingbond,denominatedinGBP.Itistherefore
notbeholdentoaparticulartaxauthority.Itisneverthelessoftenlistedonastockexchangelikethe
Luxembourgexchangewherethereisnowithholdingtax
20
tofulfillpensionfundrequirements.

AlthoughmanyofthereasonsfortheinitialgrowthoftheEuromarketsarenolongervalid,
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EuroSt
erlingmarket,continuetogro w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soexpandstheinvestoruniverse.Theglobalbondmarkethasbeenparticularlypopular
withthelargestsupranati
onalagenciessuchastheWorldBankandtheEuropeanInvestmentBank
(EIB),whowanttoensurethattheirbondscanbeboughtbybothEuromarketparticipantsandUS
domesticbondbuyers.


3.4. TypesofBonds
3.4.1. ConventionalBonds

Broadlyaconventionalbondisonethathasafixedmaturitydateandafixedcoupon.Ithas few,
ifany,bellsandwhistles(likecomplexformulaeforinterestpaymentlinkedtoequityprices,or
maturitydatesthatcanbechange d). Simplyput,itisabondthatwillpayasetinterestrateovera
predeterminedti
meandreturntheoriginalorparvalueoftheinvestmentatthismaturitydate.
Theseveryplainbondsareoftencalled“Vanilla” bonds.
3.4.2. IndexedBonds


20
Adeductionoftaxatsourcefromthecouponthatcanpotentiallybereclaimedlater.
13

Indexbon
dsarethosewhosecouponand/orprincipal
21
arenotfixedbutcanchangewith
referencetosomesortofindex.Thebestexampleofthisisindexlinkedgilts(“linkers”).Here,the
couponandprincipalrise(andfall)inlinewithinflationofferingprotectionagainstinflation.
Conventionalbonds,althoughtheymayofferahigherinitialinterestrate,canse
etheirrealvalue
22

whittledawayinahighinflationenvironment.Forthisreason,pensionfundsandinsurance
companieswithverylongterminflationlinkedliabilitieslikelinkers.However,itisworthmakinga
notethatlinkerssufferfromsignificantlywiderbid/offerspreadsthanconventionalgilts,dueto
theirlowerliquidity.

3.4.3. AssetBackedandSecuritizedBonds

Assetbackedorsecuritizedbondsaresimilartoordinarybondsbuthavespecificassetswhose
revenuespaytheinterestandprincipal.Anordinarybond’spaymentsaregenerallyguaranteedby
thecompanythatissuesthem.Inassetbackedorsecuritizedbondsasetofrevenuegenerating
assetsareputintoaspecialpurposecompanyandtheseassetspaythebondholdertheirin
terest
andprincipal.

Forinstance,EnterpriseInnssetupaspecialcompanytoholdallitspubs.Therevenuesfrom
thesepubs,aftercertaincosts,werethenusedtopaytheprincipalandinterestofthebonds.This
structureworksbecausetherevenuesarethou
ghttoberobustsotheratingagencycangivethe
bondastrongrating.Indeed,itiscommonfortheretobeanumberofbondsattachedtotheassets
withdifferentclaimsontheassets.Thebondswithstrongerclaimshavehigherrating,perhaps
“AAA”whilstthosebondswithlessercl
aimsmayonlyberated“BBB”astheyhavetowaitforallthe
otherbondstobeservicedbeforetheygettheirsliceofthecake.

Inthearenaofclimatechange,theBreezebonds(seesection4.1.4)areagoodcaseinpoint.
Thesebondsareissuedfro
masecuritizedvehicleorcompanywhichownsanumberofwindfarms
whic  fficienttopaytheprincipalinandinterest.hin turngeneraterevenuessu
3.5. IssuersaretheSupply

Withoutborrowers,orissuersofbonds,therewouldbenobondmarket.Fortunatelythereare
manykeenanddiverseborrowersrangingfrominstitutionsliketheUKgovernmenttopre‐profit‐
makingprojectfinance
23
companies.Brokersandindexcompaniesprovideausefulwayof

examiningthemarketbyprovidingindices
24
.Thereareanumberofsimilarprovidersthatnotonly
covertheUKbutalsoglobalmarkets.TheauthorhaschosentousetheMerrillLynch(ML)seriesof
bondindicesastheycoverallmarkets(UKandinternational)andarereadilyavailablewithgood
bonddata.
3.5.1. Country,IndustryandRatingsBreakdown




21
Amountpaidbackatmaturity.
22
Theirvalueadjustedforinflation.Thepriceofgoodsgoesupwithinflation.However,thevalueofa
bondwillnotandsoitbecomesworthlesswhencomparedto“real”assets.Thisisparticularlythecasein
periodsofhighinflation.Anindexlinkedgilthowever,willriseinvalueinlinewithinflationandth
ecostof
goodsandsomaintainits“real”value.
23
Acompanythatissetupspecificallytooperatealargeprojectsuchasaninfrastructureproject.
24
AbondindexissimilartoanindexliketheFTSE100index.Ithasrulesforinclusionandismarketcap
weighted.
14

Figure3showsabreakdownofthe“MLUKBroadMarketindex”(coveringallinvestment
grade
25
bonds)byeachbond’sissuercountry.Asexpected,abouthalfthenumberofbondsinthe

UKareissuedbyUKinstitutionsand con tributetooverthree‐quartersoftheindex.However,aswe
willsee,muchofthispercentagecomesfromtheUKgovernment.TherearealsomanyEuropean
companiesintheindex(li
keEoNandFranceTelecom)withover100ofthebondscomingfromUS
companies(likeGEandCitibank).

Figure3:UKInvestmentGradeMarketbyCountryofBond
Countryof
Issuer
Numbe rof
B o nds
Percent
ofindex
UK 523 76.7
US 110 4.2
France 65 2.5
Germany 61 4.2
SupraNational 50 4.1
Australia 31 0.9
Netherlands 31 1.0
Italy 30 1.3
Ireland 25 0.9
Spain 20 0.8
Other 116 3.3
Total 1062 100.0


Analternativewaytosplitthebondsisintosectorssuchascorporates(egBritis hTelecom,
Barclaysetc);quasiandforeigngovernments(RoyalBankofScotland,theItaliangovernmentand
theEIB);securitizedorcollateralizedbonds

26
(EnterpriseInns,CanaryWharfetc);andsovereigns
(onlytheUKGovernment).Table3sho
wsthesplitbytheseclassificationsand,ratherthanshowthe
numberofbonds,itshowsthenumberofissuers.Weknowthatthereareover1000bondsinthe
indexbutthatthereareonlyabout380issuers.TheUKGovernmenthas thelargestweightingbut
thelargestnumberofissuerscomesfro
mthecorporatesectorwhichcontributesto25%ofthe
indexandmorethanhalfofthenon‐giltindex.

Table3:Bondissuersbysector
 NumberofIssuers Weightinindex
Corporates 253 25%
Quasiandforeigngovernments 55 11%
Securitizedorcollateralized 67 4%
Sovereign(UKGovtgilts) 1 60%

Figure4sho
wsthebroadstructureoftheUKmarketbyboth industrysectorandrating
category
27
.Itisworthnotingthatthereisadistinctpatterninthematrixshownbytheweightsin
bold.Thatisthatthe“centreofgravity”forfinancials,industrialsandutilitiesisaratingof“A”
28
and
industrials“BBB”withsovereignsandothergovernmentbondsat“AAA”.



25

Seesection2.4.
26
Seesection3.4.3.
27
FormoredetailonCreditRatingsseeSection2.4.
28
Therehasbeenachangehereasthecentreofgravityforfinancialsusedtobe“AA”butwiththecredit
crisis,manyfinancialinstitutionshaveeitherbeendowngradedorbroughtundertheUKgovernmentAAA
rating.
15

Thesovereignsectoriscl
early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fi
nancialsector(predominantlybanksandinsurancecompanies)ismorebroadlyspreadbut
stillhasahandfulofdominant issuersli keGE(whosedebtcontributestoabout1%ofthetotal
index),Barclays(1%)andHSBC(0.8%).Thesecuritizedorassetbackedsector
29
andindustrialsector
isevenmorebroadlybasedwithnoissuersholdingmorethan0.4%oftheindex.Theutilitysector
hasslightlymoreconcentrationwithissuerslikeEDF(0.5%)andEoN(0.4%)havingreasonable
exposure.

Figure4:MerrillLynchSterlingnon‐giltindex
AAA AA A BBB Total

Sovereign
60.2
‐‐‐60.2
Quasi&ForeignGovernment
10.3
0.4 ‐ 0.2 10.9
Financial 0.8 3.1
6.5
2.4 12.8
Securitized 0.8 0.9
1.2
0.7 3.7
Utility ‐ 0.4
2.8
0.6 3.8
Industrials 0.1 1.3 3.1
3.7
8.1
GrandTotal 72.6 6.1 13.6 7.6 100.0


Figure5sho
wsthematurityofeachofthemajorsectorsinFigure4.Asweknow,theSterling
marketisa“longdated”marketandthefigureshowsthatthesecuritizedandutilitysectorsare
clearly“longsectors”.However,itisthegiltsection(notshown),becauseitissolarge,that
dominatesthedurationofthesector.

Thedurationofthemarket is importa
ntbecauseofthelikelytypeofissuancethatgreenorlow
carbonbondsarelikelytobring.Itisexpectedthatthiswillbelongandsincethemarketissetupfor

this,thissupplyislikelytobeneatlyabsorbedbyexistingendinvestorslookingforlongerdat
ed
bondsinsectorsthatdiversifytheirbondexposure.



29
Bondsthataresecuredbyaparticularsetofassets:seesection3.4.3.
16

Figure5:WeightofsectorsintheUKbondmarket
0
0.5
1
1.5
2
2.5
3
3.5
1to33to55to77to10 10to20 20to30 30to50
AggregatedWeight(%)
TimetoMaturity Bucket
Weightof SectorsinUKBondMarket
Utility Financial Industrials Se curitized

3.5.2. Gilts
WehaveseenthattheUKGovernmentisthelargestissuerintheUKbondmarketbutitisalso
importanttounderstandthekeyrolethatithasindefiningthereturnonallotherbondsinthe
market.Yieldsongiltsareoftenseenasthereferencepointforallotherbonds.Hencein
creasesin

giltyieldswilllikelyleadtoincreasesinotherbondsyields(andfallsinprices).Thisismost
pronouncedforbondsthathavethehighestratingandprogressivelyfallsasthecreditratingofa
bondfalls.Eventuallyforlowrated,highyieldbonds,giltsyieldshaveverylittleeffectonth
ebond’s
yieldorpriceasthemajorityoftheriskinthesebondsisfromtheviabilityofthecompanyandnot
fromthelevelofinterestrates.
3.5.3. OtherKeyIssuers

Anotherkeysectorthatiskeenlywatchedisthe“supraandsovereign” sector.Thisincludes
namesliketheEIB,KfWBankengruppeandtheWorldBank.Thesebondsareimportantbecause
they,likegilts,offergreatliquidity(theabilitytobuyorsellinlargesizewithoutchangingtheprice).
Theydo v
uidityasgiltsbuthavetheadvantageofofferingahigheryield.notha equitethesameliq
3.5.4. BondIssuerSize
Minimumtypicalissuancesizeforaninstitutionalinvestmentgradebond(i.e.onethatwillhave
goodliquidity)isabout£300m.Bondsthatareissuedinlessersizewillgenerallysufferfrom
illiquidity.Nevertheless,issuanceinthehighyieldsectorissmallerwithissuancesizesof£100mor
less.
3.5.5. USMunicipalBonds

17

Munibon
ds(orTaxexemptmunicipalsecurities)areoftencitedastheroutetogreenbond
financingintheUK.ItisoftenpositedthatUKlocalauthoritiescouldissueMunibondstofinance
efficiencyorotherprojects.

TheUSMunibond markethasamarketsizeofaboutUSD830billi
on
30

.Thisisabout10%ofthe
totalsizeoftheUSinvestmentgradebondmarketofaboutUSD9,800billion
31
.UnlikeUStreasury
bondsandconventionalcorporatebonds(eitherinthedomesticoreuromar ket),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pr
ojects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
financed.Thisgenerallygivesthemagoodinvestmentgraderating.

However,Munisarenotspecialbec
auseoftheirratingbutbecauseoftheirtaxstatus.Theyare
normallyexemptfromincometax.Theinterestthattheypay,viathebond’scoupon,isnotsubject
totaxationatthefederallevelandisalsousuallyexemptfromstatetax
32
.Foratax‐payingindividual
thismeansthattheyareaverygoodinvestmentcomparedtoothertypesofbond.Foraperson
payingamarginaltaxrateof,say,40%,aMunibondthatpaysacouponof4%isequivalent,after
tax,toanordinarybondpayingacoup
onof6.7%
33
.

ArelativelynewMunisectorhasrecentlybeenintroducedwhichismadeupofPACEbonds
34

(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
thiswaythepropertythat benefitsfromtheimprovementsstays“onthehook”fortherepayments
andincreasestheincentiveforthehomeownertoma
keimprovements.

MunibondscouldthereforebeausefuladditionalsourceofcapitalfortheUK.However,even
withthetaxincentive,thisUSmarketisonly10%oftheoverallmarketsocanno tbereliedonto
deliv h e
ded.ert emajorit
yoffinancene
3.6. BrokersaretheGlue
Brokersarethegluethatbringstogether“issuersandinvestors”intheprimary financialmarkets
and“buyersandsellers”inthesecondarymarkets.Ratherthananinvestorhavingtofindanother
investortobuyorsellbondsto,theygotoabrokerwhopurchasesbondsimmediatelyfromthem
andtakestheriskofon‐sel
lingthem.Iftheycan’timmediately,ordon’twantto,sellthem,theywill
warehousethemuntiltheyhavefoundanotherend‐investortosellthemto.Thisalsoworksin
reverseinthattheywillalsosellbondstoaninvestorbeforetheyhaveactuallyboughtthebo
nds.



30
MerrillLynchMunicipalMasterIndexonthe11
th

March2010.
31
MerrillLynchUSCorporateandGovernmentMasterIndexonthe11
th
March2010.
32
TheUStaxationsystemisdifferentinanumberofwaysthanthatintheUK.Inrelationtomunibonds
though,boththefederalandstatecandeducttaxfromanindividual’sincome.Munibonds,aswellasbeing
exemptfromfederaltaxareoftenexemptfromstatetaxiftheholderresidesinthestate.
33
6.7%*(1‐40%)=4%
34
 />
35
Seesection3.4.3onassetbackedsecurities
18

Brokershavegeneralskil
lsandparticularspecialtiesdependingontheirhistory,strategic goal s
andthepeoplethattheyemploy.Relationshipswithbrokersareusuallyonaonetoonebasiseven
thoughitisthecompaniesthataretransacting.

Unliketheequitymarket,therearenocommissionspaidinthebo
ndorfixedincomemarkets.
Brokersmaketheirmoneyby“buyinglowandsellinghigh”.Therearetwoprincipalwaysthatthisis
achieved,firstbymakingmoneyfromthe“bid/offerspread”and secondbymanagingabook
36
of
bonds.


Theformermethodclearlyindicatesthatbrokersareincentivizedtoincreaseflowinthemarket.
Profitsaremadebymakingasmallamountofmoneyoneachtransactionbybuyingandselling
bondsbetweencustomers.Themoretransactionstheycomplete,themoremoneytheymake
hence,theyareincentivi
zedtoincreasetheir“dealflow”withtradeideasandresearch.

Thesecondprincipalwaytheymakemoneyisthroughthewarehousedbondsheldbytraders.
Thetraderconstructsaportfoliothattheybelievewillbenefitfromthewaytheyexpectthemarket
tomove.Thisissometimescalleda“backbook”or“proptrading”andca
nrequirealargeamountof
“assetsatrisk”oftenincludingderivativepositions.Thesizeofpositionthatatraderholdsisclearly
dependentonthebroker’scapitalrequirements.

Brokersusuallyhavethreecoreteams:thesalesteam,thetradingteamandtheresearchteam.
Thesalestea
mistheteamonthephonetoclientstryingtodrumupbusinessbysuggesting
transactionsandpassingonthebestpricesfromthetradingteam.

Thetradingteam’sroleistomakeorgivepricesonallbondsthattheycoveratthemost
commerciallycompetitiveratestakin
gintoaccounttheirinventoryofbondsandtheirviewonthe
market.Theynotonlytalktotheirsalesteambuttoothertradersintheircompany(fromtheswaps,
government,corporateandotherderivativedesks),interdealerbrokers,futuresexchangesandeven
tradersinotherbrokeragecompanies.

Theresear
chteamgeneratesresearchoneconomics,companies,interestrates,yieldcurves
37

andothersubjectstogeneratesales.Thereareoftenquestionsregardingtheirimpartialityaheadof

newbondissuanceasthereisanincentivefortheresearchtobepositiveaboutthenewbonds.
Indeed,thesequestionsextendtoresearchproducedwhenthebondshaveenteredthesecondary
marketsasbrokerstendtoliketomaintaingoodrela
tionshipswiththeissuer.

Therearenumerousbrokersinthemarket.However,thebrokerswiththemostinfluenceinthe
Sterlingmarketsarethesocalled“GEMMs”
38
−theGiltEdgedMarketMakers.Inparticular,the
mostimportantbrokersintheUKmarketarethelikesofRoyalBankofScotland,BarclaysandHSBC.
ThesearethekeyhousesforbothissuingandtradingnotonlyUK‐denomina tedgovernmentdebt
butalsocorporatebondsrangingfromAAAtohighyi
eld.

TobecomeaGEMM,abrokerhastocommittotheDebtManagementOffice
39
(DMO)to
makingcontinuousmarke tsingiltstobothbuyersandsellers,althoughnottootherGEMMs.They
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se
condary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.
37
SeesectionA.4.
38
AlistofthecurrentGEMMsisinAppendixA.2.

39
ThegiltissuingarmoftheUKTreasury.
19

fromtheDMOandareableto“strip”an
d“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marke
t,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GEM Ms,whohave theirchancetoair
theirviewsonissuance,maturitiesandassetmix(conventionalandindexlinke
d).Investorsand
GEMMscanalsomakeotherrelevantpoints.ThesearekeymeetingatwhichtheDMOlearnsabout
investordemand.ThereisalsoanannualmeetingwiththeTreasu rytodiscussbroaderthemes.

Builtaroundthebroker’sgiltbusinessistheEuro‐sterlinganddomesticsterling business.

Thebid/offerspreadingil
tscansometimesbesosmallthatitiscalled“choice”,whichmeans
thatthebidandofferpricearethesame.Thebid/offerspreadintheeuro‐marketswilloftenbe
0.5%andsometime10points(i.e.10%oftheprice!).Thisisareflectionoftheliq
uidityinthemarket
asthereissignificantlymoreactivityinthegiltmarke tthantheEuro‐sterlingmarket.

3.7. EndInvestorsaretheDemand


Finaldemandforbondscomesfromfourcoreconstituencies:pension funds,insurance
companies,alternativeassetmanagementcompanies(likehedgefunds)andtheretailinvestor.The
largestsectorsareinsurancecompaniesandpensionfunds.Attheendof2008,thesetwosectors
heldabout£850billionofbondsassets
41
.Thelargestofthesewastheinsurancecompaniesthat
ownedabout£680billionofbondswiththepensionindustryowning£170billion.

Figure6sho
wsthebreakdownoftheseassetsinmoredetail.Itshowsthatboththepension
andinsuranceindustryhaveapreferenceforlongtermassets.Partofthisreasonisthatbothof
theseindustriesareheavilyregulated.Pensionindustryregulationstartedinearnestafterthe
Maxwellenquiry
42
andhascontinuedsincetoprotecttherightofthepensionerandtheirassetsin
definedbenefitpensionschemes
43
.Thepreferenceforlongtermassetsisaresultofprotecting
stakeholderrightswhohavelongtermagreements.




40
 />41
“MQ5,InvestmentbyInsurancecompanies,pensionsfundsandtrusts”,OfficeofNationalStatistics,3
rd

Quarter2009.

42
RobertMaxwellusedpensionmoneytobolsterthefinancesoftheMaxwellgroupofcompanies
includingtheMirrorgroupthatsubsequentlywentintobankruptcy.ThePensionsActof1994wasadirect
resultofthisandgavegreatersecuritytopensionfunds.
43
Adefinedbenefit(DB)pensionschemeisonewhereworkingforacompanyforasetnumberofyears
entitlesapersontoacertainpensionwhichisdependentonthenumberofyearsthattheyhaveworkedfor
thecompanyandtheirremunerationatorneartoretirement.Tosecurethis,acompanyhastoputaside
moneyinaDBpensionsc
heme.
20

Figure6:Endinvestorassets
0
50
100
150
200
250
300
350
<5yrs 5‐15yrs >15yrs Inde x 
Linked
non‐gilt Cash
Billions GBP
Insurance
pensionfunds


3.7.1. AssetsandLiabilities



Oneofthekeystoregulationisthemeasurementandassessmentofthesocalledasset/liability
mismatch.Thishelpsreducetheriskthatthepromisesmadetothepensionerorinsuredbythefund
orcompanyarenotmet.

 Apensionfund’sliabilitiesarethepaymentsthat it iscontrac
tedtomaketoboth
existingpensionersandprospectivepensioners.Thesepaymentsoftenstretchout
decadesandpossiblyasmuchas80years.Thefuturesizeandnumberofthese
paymentsisdependentonmanyfactorsamongstwhicharewagegrowth,inflationand
longevity.
 Itisdifficulttocalculatethevalueofthe
seliabilitiessincetheyhappenmanyyearsin
thefuture.Pensionfundsuseactuariestobuildmodelsthatendeavortocalcul ateor
estimatethe“presentvalue”
44
oftheseliabilities.
 Ontheotherhand, theass etsthatapensionfund ownsaregenerallyintheformof
equitiesandbondswhose valuesareknow.
 Thedifferencebetweenthesensitivityorcharacteristicsofthefuturepromises(the
liabilities)andthesensitivityorcharacteristicsoftheassetsiscall
edtheasset/liability
mismatch.
 Thedifferencebetweenthevalueoftheassetsandliabilitiesdefineswhetherthe
pensionschemeisindeficitorsurplus.
 Clearly,thereissomelinkbetweenthesensitivityoftheassetsandthesensitivityofthe
liabilities.Theyarelinkedmostclearlythroughinterestratesandin
flation.(Indeed,
thereisadirectlink betweeninflationlinkedgiltsandfutureinflationwhichiswhythey

aresopopularwiththepensionindustry.)
 However,therearemanyfactorsthatarenotcommontothevaluationofboth,suchas
longevityandequitymarketgrowth.
 Thisiswhythereisarobus
tregulatory,accountingandlegalstructuretominimizeas
bestaspossibletheasset/liabilitymismatchanditseffectonpensioners.


44
Howmuchyouwouldhavetopayanotherentitytodaytobuytheliabilities.
21


Aswellaspe
nsionlaw,variousaccountingstandardshavebeenintroducedtoformalisethe
measurementofthemismatchandalsoto,superficially,increasethetransparencyofthepension
fund.IntheUKthisstartedwithFRS17(aUKaccountingstandard)andthentheinternational
standardIAS19.TheequivalentUSstandardisSSAP24.Th
ePensionProtectionFund(PPF)wasset
upin2005toinsurepensionfundsagainstmajordeficitproblemsand,iftheworstcametothe
worst,takethemover.

Insurancecompanieshavedifferentregulationsthat,arguably,aremorerobust.

However,theseaccountingstandardsallstrugglewiththeimpossibilityofcompa
ringapples
withoranges.Theactualfutureliabilitiesaretiedtolongtermeffectsthatarenottradedwhilstthe
valueso shorttermfactors.ftheassetsareclearlyaffectedby
3.7.2. PensionFundDeficits


Possiblythebiggestobstructiontopensionfundinvestinginclimatechangeassetsaretheir
massivedeficits.AccordingtoMercers
45
,attheendof2009,theaggregatedeficitoftheFTSE350
pensionfundswas£170billion.Withaggregateassetsvaluedatabout£450billion,thisisadeficitof
27%.Inotherwordsthisis27%belowthelevelofassetsthatactuariesbelievearerequiredtomeet
thef
undsfuturepensionliabilitiesof£620billion.Thisdeficitclearlyneedstobeaddressedasitis
massive.Toputthisinperspective,attheendof2008,thesamecompaniesrandeficitsofabout
13%andsomewhatlessinpreviousyears.SimilarnumbersholdfortheentireUKdefinedbenefit
pensionschemein
dustry.

Onthelistofissuesthatpensionfundtrusteesareworryingabout,climatechangeis ratherlow
onthelist
46
.Morepressingishowtomakeuptheirdeficitsandthelegalandriskimplicationsof
allocationchangetoachievethis.Therearealsoclearimplicationsfortheirsponsors
47
,asthefund
deficitsimpactonthesponsor’saccountingrecords.Indeed,legislationcanbeusedtoenforce
paymentstothepensionfundfromthesponsorattheexpenseofdividedpaymentsto
shareholders.

Fortunately,insurancecompanieshavenotsuccumbedtothesamesortofdeficits.Partofthe
reasonforthi
sistheextraregulationthattheyexistunder.Insurancecompanies,unlikepension
funds,arerealcompaniesandhavetohaveacertainamountofcapital.
48
Theamountofcapitalthat

aninsurancecompanyisrequiredtohavebyregulationisdependentontheriskinessoftheassets
thatitowns.Themoreriskytheassets,themorecapitaltheyarerequiredtoholdandthisis
expensiveasmorecapitalmeansmoreshareholderdividends.Thishaspreventedthe
mfrombeing
too“exciting”withtheirinvestmentsbeingmoreweightedtowardsbonds.
3.7.3. ClimatechangeandPensionDecisions


Anotherbarrierpreventingpensionfundsinvesting inclimaterelatedassetsisoldcaselaw
originatingfromabattlefoughtbyArthurScargillandtheMineworkerspensionfundinthe


45
Pressrelease,January2010.
46
OnechairmanoftrusteesforalargeprivateDBschemespokentobytheauthorsaidthatnoonehad
evenbroughtupclimatechangeinthetrusteemeetings.
47
Theunderlyingcompanythatstartedthepensionscheme.
48
Thecapitalforinsurancecompaniesisequity.The“capital”forpensionfundsisthesupportoftheir
sponsoringcompany.
22

1970s.Theba
ckgroundcanbefoundinthereferencebelow,buttheimportantpointistheruling
thatcamedownsuchthat
49
:


Whenthepur poseofthetrustistoprovidefinancialbenefitsforthebeneficiaries,asisusually
thecase,thebestinterestsofthebeneficiariesarenormallytheirbestfinancialinterests.

Thishasbeen(mis)interpretedsuchthattrusteesmustseektomaximiseprofitattheexpenseof
allotherconsiderationsandpu
tasideallsocial,politicalandmoralviews−effectivelynon‐financial
information−whendecidi ngontheirassetallocation.Thishasclearlyledsomepensionfundsto
deducethattheycannottakeintoaccountclimatechangewhendecidingontheirassetallocation.

However,in2008LordMackenzie,intheHouseofLord
s,statedthattherewas“noreasoninlaw
whytrusteescannotconsidersocialandmoralcriteriainadditiontotheirusualcriteriaoffinancial
returns,securityanddiversification.”

ThisisanareathatcouldeasilybecleareduplegallyorviatheHouseofLords.Forinstance,a
clarificationofthecaseco
uldbemadenarrowingthescopeofthecaseorpensionfundscouldbe
explicitlytoldthattheycould,orperhapsshould,takeclimatechangeintoaccountintheirasset
allocationstrategy.


49
ClaireWoods“FundingClimateChange:howpensionfundfiduciarydutymaskstrusteeinertiaand
short‐termism” />23


4. e wCarbonBondsGre norLo
4.1. History
ThemajorissuersinthegreenbondarenaaretheWorldBankandtheEIBwithadditional
issuanceintheUSandsomespecificassetbackedissuance.Thebroadcharacteristicsofthesebonds

areshowninTable4.Th
esebondshavegenerallybeentargetedatretailinvestorsandsomehave
complextaxstructures.

Table4:SomeExistingGreenBonds
 WorldBank EIB Breeze CREB(2009)
Rating AAA AAA BB‐CCC AAA‐BBB
Currencies Many EUR EUR USD
Amount
Outstanding(£)
700m 750m 800m 1,500m
Return Fixed Fixedandequity
linked
Fixed Fixed
Useoffunds Broadadaption
andmitigation
projects
Renewable
energyand
efficiency
projects
Windturbine
projects
Renewable
energyprojects

4.1.1. WorldBankBonds

TheWorldBankdabbledinlate2007withEURdenominatedgree nbondstargetedatretail
investors.Thereturnonthebondswastiedtotheperformanceofan“EcoIndex”whichwaslinked

totheequityperformance ofasetofcompaniesdefinedbyABNAmro.Theoutstandingamountis 
aboutEUR230million.

Theyalsothenlaunche
dasmallbond(aboutUSD30m)thatwaslinkedtocertifiedemission
certificates(CERs).Thesewerespecificallylinkedtoparticularprojectsandagainretailtargeted.

ThefirstofthemajorseriesofWorldBankgreenbonds
50
wereissuedinNovember2008in
conjunctionwithSEBinSwedishKronatothevalueofaboutSEK3billion(£300m)targetedatboth
retailandinstitutionalinvestors.Theyhavecontinuedtoissue intheseriesasshowninFigure7.The
sizesofissuancearety
picalofWorldBankbondsandsofar,underthisprogram,theyhaveissued 
justoverUSD1billion.However,sincethefirstissuanceofthegreenbondinNovember2007,the
WorldBankhasissuedUSD51billionofgeneralbondsandnoneoftheseinGBP.




50
 /> />2010_Handbook_Environmental_FinanceforGBPage.
pdf

24

Figure7:WorldBankgreenbondissuance
Volume Coupon MaturityDate
USD300million Floating 2012
USD180Million 2.00% 2013

SEK2.85Billion 3.50% 2014
NZD150Million 5.23% 2015
AUD150Million 6.00% 2017
BRL40Million 9.50% 2017
HUF2,500Million 5.50% 2017
NOK400Million 3.75% 2017
NZD50Million 5.63% 2017
RUB750Million 7.50% 2017
SEK600Million 3.25% 2017
TRY50Million 10.00% 2017
ZAR100Million 8.75% 2017
MXN200Million 7.50% 2020
COP25M
illion 8.00% 2020

4.1.2. EIBBonds

TheEuropeanInvestmentBank(EIB)hasalsoissuedbondsin their“ClimateAwareness”
program
51
.Todatetheyhaveissuedtwobonds.Thefirstbond,in2007,wasissuedinEURtoavalue
ofEUR600m(£550m).ItsreturnwaslinkedtotheperformanceofFTSE4GoodEnvironmental 
LeadersEurope40Index.

Thesecond,twotranchebondwasmorevanillawitheitherfixedorfloatingcoupons.Th
ese
wereiss S atoavalueofSEK2.2Billion(£200m).uedin wedishKron
4.1.3. USBonds
TherehavealsobeenissuesinUSDs(liketheMunibondsalreadydiscussed)butalsoClean
RenewableEnergyBonds(CREB).TheEnergyPolicyActof2005allowedspecialtaxcreditbondsthat

allowedelectricutilitiestoreceiveinterestfreeloansforqualifyingenergyprojects.Thereisalimit
totheam th which,for2009,wasaboutUSD2
.2billionount atcanbeissued
4.1.4. BreezeBonds
52
.

TheBreezeseriesofbondsareassetbackedbonds.Theywereissuedbyacompanycalled“CRC
BreezeFinance”andaresecuredonanumberofwindfarmsmainlyinGermany.Thereareseven
bondsoutstandingtotalingaboutEUR900million.

Thebondsarestructuredsothattherevenuesfromthewindfarmspayin
terestandcapitalback
onthebonds.Thisisclearlyanimportantstructureasitisusingthebondsmarketsdirectly,rather
thanthroughthebanks,tofinancerenewableenergyprojects.

Thecharacteristicsoftherevenuestreamfitneatlywiththeneedsofbondinvestors.Thewind
thatpowerstheturbinesisreasonablyconsistentyea
rtoyear.Thewindturnsthegeneratorswhich


51
2007EPOSIIClimateawarenessprospectusat
/>52
 />25
