Does Green Bond Improve Portfolio Diversification? Evidence From China

Green bonds are a type of fixed-income instrument that is specifically used to raise funds for projects with environmental benefits to mitigate and adapt to climate change. China's green bond market expanded rapidly in recent years due to national push for net-zero emissions and the growing appetite of investors. However, little is known about the investment benefits of green bonds from the perspective of portfolio optimization. This paper investigates whether green bonds offer better risk-return profile compared to conventional bonds in China. We compare the out-of-sample diversification benefits of green bonds and conventional bonds using various asset allocation strategies. The results show that the portfolio with green bonds leads to higher risk-adjusted returns than the portfolio with conventional bonds across different asset allocation strategies and risk aversions. This is mainly due to the increase in returns after including green bonds in the portfolio. Overall, our findings suggest that China's green bonds should be included in optimal portfolios