An income investing opportunity focused on clean water is gaining traction as extreme weather events repeatedly raise the alarm of climate change. “Blue” bonds, securities focused on protecting bodies of water, are popping up with increased frequency with the help of nonprofits. Many of the bonds are debt-for-nature swaps that allow investors to help small countries repay their debts and support aquatic health and biodiversity at the same time. The idea is to direct finance toward ocean-based projects to show environmental, economic and climate benefits. They are considered a cousin to “green” bonds , but more narrowly focused solely on water. Green bonds, issued by governments, corporations or financial institutions with the proceeds earmarked for environmental or climate change projects, encompass a wider remit. Both green and blue bonds are attracting wider interest as the toll of climate change — be it drought, flood, sea rise, hurricane, typhoon, tropical storm or wildfire — grows costlier, especially for coastal communities. The market has advanced over the last half decade. The Seychelles, a country of 115 islands in the Indian Ocean, is believed to be the first to issue a sovereign blue bond in 2018. The $15-million bond, structured with support from The World Bank , was aimed at boosting environmentally friendly marine and fishing initiatives. “This is an area that requires growth,” said Kris Atkinson, a portfolio manager at Fidelity International focused on climate. “Both in terms of investment, but also sort of raising awareness of it as an issue, because it clearly has significant importance.” Other countries, including Fiji and Portugal, have joined the bandwagon, and investors in the field expect more issuers to come to market. The Nature Conservancy recently launched a blue bonds initiative , creating guidelines to help countries pursue debt swaps. In June, the United Nations ratified a treaty aiming to protect at least 30% of terrestrial and inland water areas by 2030. That would mark a meaningful improvement, as only around 1% of international waters currently have limits on fishing and mining, according to Nomura. While sovereign bonds have been the most common, Nomura also pointed to corporations and municipal issuers testing the market. AXA investment managers issued a blue bond, while the Inter-American Development Bank was involved in pricing a series of them. Earlier this month, Denmark’s renewable energy producer Ørsted said it would become the first energy company to issue blue bonds. ‘A hugely under-invested area’ Despite the growth, it’s still a tiny market, even in the environmental, social and governance (ESG) world. Blue bonds comprise just a fraction of the market share of green bonds, which themselves only make up just a few percent of the total bond market, according to Fidelity’s Atkinson. “It is a hugely under-invested area,” Atkinson said. “There has yet to be a sort of concerted effort to develop this market … into something that has impact in the same way as the green bonds space has.” But he said there likely won’t be more options until there is wider demand for those blue bonds already available. Meanwhile, many investors will likely remain on the sidelines while waiting for the market to grow and mature. Aya Kawamoto, head of structured syndicate in Europe, the Middle East and Africa for Nomura, said there isn’t yet enough supply of blue bonds. Nomura was involved in a bond that Japan’s T & D Financial Life Insurance invested in. While there’s hesitation from potential buyers, those involved in the space are quick to note the positive environmental impact of blue bonds. The Nature Conservancy, which has helped Barbados and Belize with bond issues, pointed to the fact the Seychelles has exceeded its goal of protecting 86 million acres of ocean. Morgan Stanley analyst Simon Waever said the climate focus can help attract guarantors to a blue bond, leading to higher credit quality and lower coupons. Between the improved quality and ESG label, a broader scope of investors should theoretically be enticed. “These swaps should be thought of as a liability management tool with an additional ESG benefit rather than an ESG financing mechanism,” Waever said in a note to clients in June. “Although these are not directly financing mechanisms, they do have the ability to free up fiscal space and to benefit sovereigns with high debt burdens.” Waever said more banks are participating on the syndicate side of debt-for-nature swaps, while other organizations are increasingly jumping in on the guarantor side. He also noted that their performance could mark a turning point: Similar offerings focused on industries such as health care, education or food could follow if blue bonds prove successful. To be sure, Atkinson said blue bonds are currently in a similar stage to where green bonds, their better-known “cousin,” were about half a decade ago. But he said it may not take as long for blue bonds to catch up in scale, given the path of their green predecessors. Experts say two factors restricting blue bonds is the lack of uniform goals and measuring success. Green bonds that stress lowering carbon emissions are considered more advanced due to a broader consensus around their goals. But a group of organizations is currently working on guidelines with the hope of universal acceptance, which market participants hope will enhance blue bonds’ legitimacy and uptake. Nomura’s Kawamoto said the U.N. treaty alone can help the blue bond market “take off.” ‘A good way to start’ In this environment,Fidelity’s Atkinson said that while it would be fairly easy to find a blue bond to replace a 5-year U.S. Treasury note , for example, it would be harder to swap one for a corporate bond. Because of this, he recommends investors look beyond blue bonds to green bonds that have some focus on water issues. He also said companies whose products or services support water health can be a place to hunt for eligible securities. Still, Atkinson said blue bonds could make up between 5% to 10% of an investor’s “labeled” bond portfolio, referring to those with some type of ESG tilt. The question then becomes how much each investor wants their portfolio to contain ESG-focused options. One interesting blue bond issuer is Gabon, Atkinson said, noting the Central African country’s blue bonds offer an attractive yield, while also offering solid capital security given their guarantee structure. He also agreed with Waever that these bonds can support the countries themselves by easing debt burdens, but noted the need to weigh the strength of sovereign guarantees. Gabon, for example, is currently in the midst of a military coup . Ultimately, Atkinson said investors should not let “the perfect be the enemy of the good” when evaluating these new securities. “We’re not going to claim that we’re going to go straight from bad environmental actor to great environmental actor overnight,” he said. “We have to make incremental steps. And we think that that is a good way to start.” The primary investment thesis behind blue bonds, Atkinson said, is understanding the risk of ignoring the need for healthy oceans and clean water. He said investors should think of blue bonds as a way to support socioeconomic development given the economies and industries that are directly tied to ocean quality and biodiversity. “This is something that you really need to be thinking about when you’re investing,” Atkinson said. “If you’re not, then you’re ignoring a pretty major risk on the near horizon.” — CNBC’s Michael Bloom contributed to this report
A little-known income alternative tied to clean water