InvestmentsApr 21 2022

The outlook for sustainable fixed income

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Columbia Threadneedle Investments
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Supported by
Columbia Threadneedle Investments
The outlook for sustainable fixed income

One of the strongest narratives driving market trends in recent years has been the rise in client interest for sustainable or other types of environmental, social and governance mandates.  

The latest data from the Investment Association shows this demand has survived recent market conditions, with a net inflow of £280mn in February into ESG-focused open-ended funds, bringing the total to £28bn, or 5.5 per cent of the assets under management of the open-ended fund market – a proportion that has roughly doubled over the past decade. 

The vast bulk of those assets are held within equity mandates, and many of the trends and dynamics that move sustainable equities are well known.

But there are also responsible fixed income funds, though those are much smaller in number, and the thematic and macro drivers of the performance of such funds are less well known. 

Government bonds

A major question clients and providers alike have had to grapple with is whether to use government bonds in responsible investment portfolios, given that most governments deploy budget to funding armies and military spending.

But if one ignores government bonds, how can diversification be achieved? 

It may be that the question marks over whether to include government bonds have held back the development of the sustainable fixed income sector, with sovereign debt having been about three-quarters of all issuance a decade ago in this space, according to Sandra Crowl, stewardship director at Carmignac. 

 Changing ESG investing preferences for a more sustainable future guarantees that fixed income investment won’t be left behind.Sandra Crowl

In total, there are just over 60 bond funds that brand themselves as ESG or sustainable, roughly half the number of sustainable funds available in the open-ended equity universe, according to data from FTAdviser's sister publication Asset Allocator. 

Crowl says: “Despite still being underserved for the investor demand, investors also now have a choice. While 10 years ago sovereign bonds made up around 74 per cent of total issuance, today financial corporate bonds make up 25 per cent, non-financial bonds 35 per cent, and sovereign bonds 40 per cent.” 

Just as the regulatory outlook has impacted demand for equity mandates, it has, and will, also boost demand for ESG fixed income funds, according to Crowl.

She says: “The EU green deal for green financing, the EU sustainable finance regulation and changing ESG investing preferences for a more sustainable future guarantees that fixed income investment won’t be left behind.” 

Green investment bonds

One of the ways the market has tried to resolve the conundrum of whether government bonds can ever be ethical is via the the creation of so-called green investment bonds, which allow for bonds to be issued by governments and companies with the revenue hypothecated (that is, ring-fenced to be deployed only to specific projects), allowing the bond investor greater clarity that their capital will be deployed only in a way that is aligned with their priorities. 

Perhaps indicating that investing in government bonds is a problem, the launch of green gilts by the UK government, alongside more corporate issuance, has seen the number of green bonds on the market double in two years, according to Crowl.

 

But she is cautious about the investment case for those assets right now, pointing out that most trade at a lower yield than the conventional bonds by the same issuer, and adds that one needs to be cautious around what some of the green corporate bonds are actually invested in.

She says: "Beware, sustainability bonds don’t all meet the same ESG standards and now a new bond class has appeared: the sustainability-linked bonds for which the issuers set sustainable objectives on their own operations, with no sustainability link with the proceeds of the bond."

Analysis from multi-national bank ING indicates that in the corporate bond fixed income space, green investment bonds offer on average three basis points (0.03 per cent) lower yield than the same bond with the same maturity issued by the same company but without a sustainability objective. 

The research found that in times of severe market stress, the gap between the two narrowed as investors focused on the more conventional bonds. 

Transparency 

Thede Rust, head of emerging markets debt at Nordea Asset Management, says one should think of bonds of this kind as “use of proceeds bonds”, and says such products are no longer limited to funding environmental causes, but also social causes. 

He says: “One of the things to look out for, if these are corporate bonds, is whether they are linked to key performance indicators for the companies; is the outcome that clear cut? For example, a cement company might issue a bond for its general activities, but then issue a sustainable bond to reduce its carbon footprint by a stated amount over the lifetime of the bond.”  

 Beware, sustainability bonds don’t all meet the same ESG standards.Sandra Crowl

He says investors need to ensure that there is clarity around how the funds raised from a bond issue will be used. 

Andrew Lake, head of fixed income at Mirabaud Asset Management, has about 50 per cent of the capital in one of his funds invested in green bonds of various kinds, but mostly in government-backed projects where one has clarity around where the capital is going. 

He says that while clients are justifiably focused on investing in areas such as renewable energy or electric cars, it is also essential that the infrastructure needed to enable those things is built. He adds this task typically falls to governments, who issue green bonds to achieve this, and allows him to be exposed to areas such as infrastructure, which are government administered but also provide an income stream that a client can be sure is not linked to military spending. 

david.thorpe@ft.com