The outlook for sustainable fixed income

This article is part of
Guide to fixed income and responsible investing

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. 

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.