The green bond market has grown rapidly in the past four years, from $11 billion in issuance in 2013 to approximately $120.2 billion1 in 2017, as more issuers access private sector capital to finance investments required to achieve the goals specified in the 2015 Paris Agreement. Strong and growing investor demand has further fueled the growth in green bond issuance.
As the green bond market matures, there is also increasing diversification in the types of green bonds being issued. Compared to 2013 where green bonds were predominantly issued by development banks, now corporate bonds and asset backed securities (ABS) comprise 36% and 6% of total green bond issuance2 respectively.
In this article, we’ll examine the relative value of green ABS, and highlight our analysis of a recent green ABS issued by Tesla Energy (formerly SolarCity) that we purchased for the Pax Core Bond Fund (PXBIX).
Green ABS include securitizations of loans and leases related to low carbon assets such as solar photovoltaic (“PV”) systems, and securitizations of auto and commercial real estate loans with proceeds used to finance green projects. Securitization can be an attractive way for green bond issuers to access the capital markets, reduce their cost of funding, and broaden their investor base.
For asset managers, green securitizations are another way to increase impact investments, and they can offer attractive relative value compared to other green corporate bonds and similarly rated non-green investment grade (IG) bonds.
As illustrated in Exhibit 1, certain green ABS such as Tesla Energy’s TES 2017-2 trade at higher spreads relative to other green bonds such as Apple and International Bank for Reconstruction and Development (IBRD), and to non-green, “A” and “BBB” rated investment grade corporate bonds with comparable maturities.
Exhibit 1: Relative Value within Investment Grade Fixed Income
Source: Bloomberg. CMBS stands for Commercial Mortgage Backed Securities, MBS stands for Mortgage Backed Securities.
Indicative spreads3 as of December 29, 2017
Thorough credit analysis is essential to evaluating the risk-reward of green ABS. While certain tranches of green ABS have investment grade ratings, they trade at wider spreads relative to other investment grade bonds due to the limited performance history of their underlying collateral and the structural complexity and analysis required for such securitizations.
To better understand what goes into the analysis of a green ABS, let’s take a look a recent solar ABS that we purchased, Tesla Energy’s TES 2017-2, LLC Solar Asset Backed Notes, Series 2017-2 (“TES 2017-2”).
TES 2017-2 is a $130 million securitization of cashflows related to host customer payments and government administered performance based incentives (“PBI”) on more than 12,000 residential PV systems. The securitization uses a special purpose entity to mitigate bankruptcy risk between Tesla Energy and the issuer (TES 2017-2) and achieve lower cost financing from TES 2017-2’s fixed income investors. The securitization also monetizes the investment tax credits associated with Tesla Energy’s PV systems by transferring them to the tax equity investors via a complex financing structure (Exhibit 2). TES 2017-2’s tax equity investors are forecast to achieve their target after-tax returns in year 7 (the “anticipated repayment date”), whereby Tesla Energy is expected to refinance the solar assets via more efficient terms.
Exhibit 2: TES 2017-2 Flow of Funds
Source: TES 2017-2 LLC final offering circular, summarized by Pax World Management LLC. As of 12/4/17.
TES 2017-2’s Class A notes (“A-” rated, 6.7 year weighted average life) priced at a spread of 185 basis points4 (bps) over the U.S. interest rate swap curve.5 This compares favorably to 5-year BBB rated investment grade corporate bonds, which in December of 2017 traded at spreads in the 90 bps area.
The additional spread on TES 2017-2 can be attributable to several factors. Solar securitizations have complex and non-standard structures compared to other ABS, such as autos and credit cards. Additionally, historical performance data on residential rooftop solar systems is limited, making it difficult to forecast the cashflows of these longer dated, typically 20-year term contracts. Moreover, the average solar securitization is less than $150 million; the small transaction size limits broader investor participation and secondary market liquidity.
We evaluated the credit quality of TES 2017-2’s underlying collateral, the securitization structure, as well as various structural, operational, legal and regulatory risks. We believe several transaction features help to mitigate the above risks.
These positives help to mitigate various risks in the transaction, such as the limited performance history of rooftop solar panels, the extension of the anticipated repayment date, the failure of Tesla Energy to refinance the transaction, and changes in solar investment tax credit regulations. We conducted scenario analysis and believe that TES 2017-2’s transaction structure should adequately protect the Class A investors.
Spreads on most fixed income asset classes are currently at multi-year lows, with limited room for improvement. Green ABS can provide diversification from credit risks associated with corporate bonds and benchmark ABS. With thorough credit analysis, we believe investing in certain green ABS can further add value to the Pax Core Bond Fund.
1Climate Bonds Initiative, as of December 29, 2017.
2“Green Bonds Market Summary: Q3 2017”, Climate Bonds Initiative.
3Spread is the difference in yield on different securities.
4One basis point is equivalent to 1/100th of 1%, 0.0001. This is a common unit of measurement of changes in interest rates.
5The swap curve identifies the relationship between swap rates at varying maturities.
6Final Offering Circular: $130,915,000 TES 2017-2, LLC Solar Asset Backed Notes, Series 2017-2.
Yield and share price will vary with changes in interest rates and market conditions. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. Mortgage related securities tend to become more sensitive to interest rate changes as interest rates rise, increasing their volatility. There is also a chance that some of the fund’s holdings may have their credit rating downgraded or may default.
Diversification does not eliminate the risk of experiencing investment loss.
Credit ratings apply the underlying holdings of the fund, and not to the fund itself. S&P and Moody s study the financial condition of an entity to ascertain its creditworthiness. The credit ratings reflect the rating agency’s opinion of the holdings financial condition and histories. The ratings shown are all considered investment grade and are listed by highest to lowest in percentage of what the fund holds.