Mind the (duration) gap: from risk to opportunity in green bonds

Mind the (duration) gap: from risk to opportunity in green bonds

The recent decline in bond yields serves as a reminder of the potential benefits that high interest rate sensitive bonds can offer to investors. However, it is important to note that this I overshadowed by the significant increase in interest rates over the past three years.

Just like yields and credit spreads, duration is a metric that varies across different markets and time periods. Investors should be mindful of the “duration gap” across markets as it can turn from risk to an opportunity.

As we approach the end of the year, brokerage firms are releasing their market outlooks, some of which indicate a potential decrease in yields and significant rate cuts. It is crucial to reassess investors’ perspectives on duration, particularly in the context of the green bond market, which has been affected by its extended duration. This presents a potential opportunity for investors.

Duration 101: Higher yields, lower prices and…lower duration

Duration is a measure that quantifies how a bond’s price changes in response to a parallel shift in interest rates. This relationship is inverse, meaning that higher interest rates result in lower bond prices, and vice versa. However, it’s important to note that duration is not a fixed measure. As bonds approach maturity, their sensitivity to interest rate changes decreases as the principal payment becomes a larger portion of the bond’s price. In addition, when all-in-yields (interest rates and credit spreads) rise, duration decreases as there is more yield to offset future potential increases. Market dynamics, such as net bond issuance and new bond issue tenors, also influence duration at the index level.

Higher yields, lower prices and…lower duration

Source: Asteria Investment Managers, ICE Index, monthly index changes from 2020 to October 2023.

Mind the duration gap

The period of historically low interest rates has led to an overall rise in duration across fixed income indices, reaching record levels in 2021. However, this increase has been uneven, particularly for green bonds which have experience a growth of over 6x since 2019. As a result, the green bond market (globally and in Europe) has significantly longer average maturities compared to broader market indices.

Mind the duration-gap: duration is not static across markets

Source: Asteria Investment Managers, ICE Index.

The higher duration of green bonds has posed a significant risk and has contributed to underperformance, particularly in 2022 when Euro Green Bonds underperformed the Euro Broad Market by nearly 4%.

From risk to opportunity: green bonds a catch-all opportunity?

Albeit painful, the decline in duration of green bonds can present an opportunity for investors. This is particularly true, if investors share the views of certain firms calling for interest rate cuts, as this would benefit green bonds given the higher duration. On the other hand, investors who anticipate a “higher for longer” scenario are less likely to be affected by the historically high duration of green bonds. Moreover, the decreasing duration gap now provides an opportunity to allocate towards a sustainable fixed income solution, regardless of investors’ duration outlook.