Core Focus: The eligibility of green bonds as reserve assets, their liquidity and safety characteristics, and the empirical evidence on their diversification benefits.

In-Depth Notes:
Green bonds represent one potential approach to ESG integration in reserve portfolios. For green bonds to be considered suitable investments for central banks, they must satisfy key portfolio requirements—ensuring security, liquidity, and profitability. The BIS has examined these characteristics in depth.

Green Bond Liquidity:
An instrument is said to be liquid if transactions in it can take place rapidly and with little impact on price. Green bonds face two key liquidity challenges. First, the stock of instruments available for investment is limited. At current levels, the US dollar and euro segments each represent only about 6.5% of global FX reserves, limiting the scope for investments. Outstanding amounts continue to be small relative to their conventional comparators, with $750 billion worth of green bond volumes compared with almost $120 trillion worth of conventional securities.

Second, green bonds tend to be more costly to buy and sell, trading with wider bid-ask spreads than their conventional counterparts. The term structure of bid-ask spreads suggests that green bonds may not be eligible for the liquidity or working capital tranches of central banks’ reserve portfolios.

Green Bond Safety:
The safety of green bonds is assessed primarily through credit ratings. Research shows that the ratings compositions of green and conventional bond markets have broadly converged, supporting eligibility. Although green bond at-issuance ratings in 2014 were more concentrated in the lower end of the investment grade spectrum, this predominance has gradually waned. By 2019, high-graded green bonds (above BBB+) represented about 65% of new issuance, broadly comparable to the conventional comparator market.

Diversification Impact of Green Bonds:
Research using Markowitz’s portfolio optimisation model—incorporating traditional central bank investment assets such as government bonds, corporate bonds, stocks, gold, and green bonds—has examined the impact of green bonds on portfolio risk and diversification. The findings suggest that adding green bonds to a central bank’s portfolio has neither a significant impact on portfolio risk nor a notable effect on diversification. Moreover, portfolios containing green bonds exhibited similar responses to COVID-19 shocks as those without them.

The results indicate that while green bonds do not contribute significantly to diversification, they also do not elevate portfolio risk. Therefore, central banks may consider investing in these instruments primarily as part of their commitment to social responsibility rather than for improving portfolio performance.