۱- Introduction

۲- Data and method

۳- Empirical results

۴- Conclusions

References

Abstract

This study analyses how liquidity risk affects bonds’ yield spreads after controlling for credit risk, bond-specific characteristics and macroeconomic variables. Using two liquidity estimates, LOT liquidity and the bid-ask spread, we find that, in particular, the LOT liquidity measure has explanatory power for the yield spread of green bonds. Overall, however, the impact of LOT decreases over time, implying that, nowadays liquidity risk is negligible for green bonds.

Introduction

This study investigates the effects of the liquidity premium on the green bond yield spreads. We control for credit risk, as well as bond-specific and macroeconomic factors. Liquidity concerns may be pertinent in green bonds market due to (1) its disproportional thinness, and (2) its unclear solvency profile. The demand for green bonds is likely to surpass the supply due to investors’ need to address the ESG (Environmental, Social, and Governance) and SRI (Social Responsible Investment) mandates. In addition, green bonds show low correlation with other fixed income securities and provide diversification benefits to investors (Inderst et al., 2012). Despite the rapid growth of green bonds’ demand in the market, the supply of green bonds is insufficient due to: (1) a lack of fiscal incentive for green investment (Zerbib, 2017), and (2) a lack of an official and universal classification system for green bonds that is in accordance with market based frameworks, such as, the Green Bonds Principle (Cochu et al., 2016). The latter might cause opacity on the definition of “green” investment and bonds, and issuers will be subject to additional transaction costs, e.g., contracting with external reviewers pre and post green bonds’ issuance. This leaves the issuance of green bonds less attractive than that of conventional bonds. Due to the shortage of green bonds’ supply in the market, issuers are able to offer green bonds at lower interest rates, relative to the wider bonds market (Preclaw and Bakshi, 2015; Bloomberg, 2017; Zerbib, 2017). However, the shortage of supply and the excess of demand in green bonds market imply a thin market, and, liquidity becomes relevant. Consequently, a liquidity premium may emerge. The second factor that may cause illiquidity in the green bonds market, such as, a lack of credit risk profile, is partly endogenous for the issuers. Cochu et al. (2016) put forward that the green bonds’ credit risk profile is unclear, since: (1) transparency in the reporting of green projects is lacking, and (2) the ratings of green bonds rely heavily on the balance sheets of the issuers instead of green project investment.