Minimum connectedness portfolios and the market for green bonds: Advocating socially responsible investment (SRI) activity

Abstract

Socially responsible investing (SRI) such as issuing green bonds is increasingly widely adopted, moving into mainstream investment activity. In this study, we consider China, Europe and the US, in order to investigate (i) co-movements across and within the respective markets for green and traditional bonds in these regions and (ii) whether green bonds enhance the value of fixed-income investment portfolios. We pay particular focus on connectedness during the outbreak of the COVID-19 crisis. To achieve our objectives, we employ a time-varying parameter vector autoregressive (TVP-VAR) connectedness framework and four multivariate portfolio construction methods, for the period between July 2016 and December 2020. 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. Results indicate that connectedness is intensified in the first quarter of 2020; however, the effect is not permanent. During this period, both green and black Chinese bonds, as well as green US bonds intensify their role as net recipients while, both green and black EU bonds weaken as net transmitters of pricing shocks while, black US bonds assume a net transmitting role. Overall, investing in green bonds results in more efficient portfolios. Finally, we show that the minimum connectedness portfolio achieves the highest Sharpe ratio and significantly reduces the investment risk.