There were no subtleties within the United Nations sixth assessment report released at last week: The Earth is on track to get (at least) 1.5 degrees hotter in the next 20 years, and humans are to blame for it. As residents that means we can start readying ourselves for more fires, flooding, droughts, food shortages, and animal extinctions.

But the report—and the ramifications of climate change—have some powerful implications for investors as well. “We do have the capital resources—there’s no doubt about that—but we have to change things quite quickly,” says Sean Kidney, CEO of the Climate Bonds Initiative, an international organization promoting low-carbon investments that certifies green bonds.

All this is to say, green bonds are having a moment in the spotlight. The market surpassed $1 trillion in assets last year, with $290 billion in green bonds issued in 2020, according to Morningstar. In 2021, issuance is projected to hit $500 billion. To be sure, it’s a relatively small slice of the global bond market (about 1% to be exact), but it’s expanding quickly. “This is probably one of the fastest growing areas” in the bond market, says Jose Garcia-Zarate, who researches fixed income at Morningstar. There are 128 global asset managers representing $43 trillion in assets that have committed to helping hit the goal of net zero greenhouse gas emissions by at least 2050. Investors have invested some $2.24 trillion in sustainable mutual funds and ETFs by the end of June. That’s 12% more than there were only three months prior.

Not only are green bonds a tangible way corporations, asset managers and municipalities are funding sustainable projects—they're also a way for investors to pinpoint the impact of the dollars they've investing while also generating a return. Here's what investors should know.

What’s a green bond?

Green bonds are debt that is … well … green. They’re structured the same as traditional fixed income securities, but earmarked for projects explicitly contributing to reducing the carbon footprint (think water projects, energy-efficient buildings or electric vehicles).

A reminder of how bonds work: It’s effectively a loan made by an investor to a corporation, municipality or government agency to fund operations or a project. Bonds have specific end dates, called “maturity dates,” where the issuer must return money to the investor. The company or agency pays an investor interest throughout the duration of the bond.

Green bonds have the same structure as their non-green counterparts, so they theoretically carry the same credit structure. “The idea was simply a bond that could … have the same risk and yield characteristics of any other bond but have a bonus feature” where the investments would address climate change. “That's it. Nothing more complicated than that,” Kidney says.

A trillion-dollar sector

The first green bond was issued by the European Investment Bank in 2007, focused on renewable energy efficiency. It wasn’t until 2013, when the first corporations—EDF, Bank of America Merrill Lynch and Vasakronan—issued green bonds that the new products started taking off. By the end of that year, the green bond market had reached $11 billion in assets, tripling in size.

Verizon raised nearly $1 billion in an issuance in 2019 for things like renewable energy projects and upgrading its facilities to energy-efficient lighting across its facilities; and Apple funded 17 green bond projects in 2020, some of which are part of its effort to go carbon neutral by 2030. Particularly during the pandemic, local governments have been using municipal bonds to fund capital projects—and increasingly green ones. S&P Global Ratings identified 176 unique issuers of green muni bonds from 2020 in a report earlier this year, and 109 of those were first-time issuers. It predicts that the U.S. municipal green-labeled debt sector will make up about 4.1% of all municipal issuance by the end of this year.

There’s a flood of demand for sustainable funds and investments in general, and there aren’t enough bonds to keep up with it. “Every green bond that comes out is oversubscribed: anywhere between three and 10 times,” Kidney says.

How to invest

Right now, the primary bond market—green or not—is heavily saturated with institutional investors like pension funds, insurance companies or hedge funds. The secondary market (where investors are purchasing bonds from other investors, rather than the issuers themselves) is growing, too, although that’s still niche as well.

Some initiatives are making it easier for everyday individuals to gain direct access. The U.K. recently said it was issuing a suite of green bonds particularly targeted at retail investors, although details are limited thus far. Green, social or sustainable muni debt in the U.S. is largely bought by domestic retail or individual investors, according to Climate Bond Initiative research. Some municipal bond investments available to retail investors last year were in North Texas or Seattle. Retail investors can purchase individual muni bonds through a bond dealer, brokerage or bank, or through a financial advisor. It can be complex, and there may be high fees or minimums.

A more diversified way for retail investors to gain exposure to green bonds is through pooled investment vehicles, such as mutual funds or ETFs. As of May 2021, there were 76 green bond funds globally with around $25 billion in assets, according to Morningstar, with 65 of them being housed in Europe. Here are a few of the funds available: The iShares Green Bond Index Fund (IE), which is domiciled in Ireland, is the largest green bond fund with some $3.4 billion in assets. There’s also the Lyxor Green Bond (DR) UCITS ETF, the VanEck Green Bond ETF (GRNB) and the TIAA-CREF Green Bond Fund, just to name a few.

Not a fixed income substitute

Before anyone rids themselves of the traditional bonds in a portfolio in favor of saving the Earth and making the same returns, just know that, as of right now, that doesn’t really work.

The green bond market is weighted differently, as most of this debt is being issued in Europe and—in the U.S.—specifically by corporations. If an investor were to swap out the iShares Global Aggregate Bond ETF for its green bond ETF, exposure to the euro would increase to 68% from 23.6%, and exposure to U.S. bonds would lower to 20.7% from 42%, according to Morningstar.

Due to green bond funds being weighted differently, they will perform differently, too. The iShares Global Green Bond ETF, for example, had a 1-year total return of 1.12% at the end of July. A more-traditional bond counterpart, the iShares Core Global Aggregate Bond UCITS ETF, had a lower 1-year total return , at 0.63%.

It can be difficult to adequately compare the funds when green bonds are so relatively new in comparison (nearly all of them around for less than three years), and particularly when the yields for bonds are at all-time lows in the U.S. and Europe during the coronavirus pandemic. As more companies and governments issue green bonds, it's also likely that green bond funds won't be as heavily weighted in the euro in the future, according to Morningstar.

These factors aside, some of the funds have experienced promising returns in the long-run thus far, including the NuShares ESG U.S. Aggregate Bond ETF (NUBD), which launched in 2018 and has a 3-year total return of 5.34%. It was down -0.88% from the end of July from January. The VanEck Vectors Green Bond ETF (GRNB) had a 3-year total return of 3.82% at the end of July, but was down -0.45% from January. One of the most popular traditional bond ETFs, the Vanguard Total Bond Market ETF (BND), performed better than both these funds over the last three years, with a total return of 5.83% at the end of July. It was down -0.63% at the end of July from January.

There are a few other things investors should keep in mind. For one, fees. Green bond funds do tend to be more expensive: The two U.S.-domiciled green bond ETFs cost 0.25% per year. That's compared with 0.08% or 0.09% for a more general bond ETF, according to Morningstar. ESG investments, in general, sometimes don't benefit from the same economies of scale as their counterparts, and they can have extra costs for things like shareholder advocacy. Other key differentiators: Green bonds have a higher average duration, but a lower average yield to maturity than standard bonds. Green debt funds tend to have more exposure to BBB rated bonds (which typically corresponds to a search for a higher yield)—meaning they have higher exposure to credit and duration risk.

Investors should always do their own due diligence, too: Start by looking into the projects the bonds intend to fund. “Investors will need to carefully look beyond the label,” as more companies issue this debt, Peter Ellsworth, senior director of the Ceres Investor Network, a sustainability-focused non-profit organization that works with capital markets leaders, wrote in an email. Ellsworth suggests investors consider whether the proceeds align with established criteria, such as the European Green Bond Standard or Climate Bonds Initiative, and that an investor examines the issuer’s broader commitment to a low-carbon future.

The bottom line? Right now, Morningstar says green bonds are best used as a complement to a portfolio, rather than a substitute, for regular bonds.