Minimum Connectedness Portfolios and the Market for Green Bonds: Advocating Socially Responsible Investment (SRI) Activity

Abstract

Socially responsible investment (SRI) practices are increasingly widely adopted, and moving into mainstream investment activity. Among the suite of instruments available to responsible investors is a fixed-income offering known as a green bond - a specialized bond in which the use of proceeds are strictly earmarked for projects with an explicit ‘green’ orientation. The market for green bonds was established in 2007, and in recent years is achieving a phase of maturity. Notwithstanding this, there is as yet scant evidence or empirical insights around their potential value to investors. Here we question whether green bonds have a (value-enhancing) role to play in a balanced fixed-income investment portfolio. We phrase our analysis around international bond indices, for green versus black bonds in the three major market regions for green bonds, namely the US, Europe and China. A time-varying parameter vector auto-regression (TVP-VAR) econometric framework is applied to daily data - spanning July 2016 to April 2019 - to examine aggregate network, and pairwise dynamics as they have evolved through time and illustrate the evolving nature of connectedness between these core bond-market benchmarks. Following this, bond portfolios are constructed with dynamic weighting schemes (including a novel ‘minimum connectedness’ portfolio) to question, if, when and to what extent green bonds are part of an international fixed-income investor’s portfolio. The results indicate a non-trivial role for green bonds, with weights ranging from approximately 40% to 80% depending on time, and portfolio construction choice. Chinese green bonds typically have the largest weight of the green bond indices, especially under minimum-variance portfolios, while in the preferred ‘minimum connectedness’ portfolio there is a much more balanced representation of US, European and Chinese green bonds. Our analysis contributes unique evidence to the literature on the role of SRI practices as a complement to mainstream investment.