Investors often think of ESG in terms of their equity portfolios—but they can also align their fixed income allocations with their principles. Here’s how.
Environmental, social, and governance (ESG) investing is a more recent development in the fixed income markets than in the equity markets. We continue to see increasing interest from clients about how to incorporate their ESG values into the fixed income portion of their investment portfolios. However, many investors still have some hesitations about applying responsible investing frameworks or screens to their bond portfolios due to widely held misconceptions around ESG investing. Let’s take a look at some common questions.
Do responsible investors have to sacrifice returns?
It’s a widely held concern among investors that ESG investments will underperform traditional investment strategies. Some of the rationale stems from the smaller universe of potential investments for those seeking social and environmental impact. Having a framework for evaluating bond issues according to ESG principles can expand the pool of potential impactful investments beyond explicitly labeled green, social, or sustainable bonds, which still account for a small percentage of overall fixed income issuance. This larger universe of prospective unlabeled investments presents an opportunity to uncover relative value in the market and allows investors to achieve both strong social and financial returns in their ESG portfolios.
A related concern is that bonds labeled green, social, or sustainable will yield less than standard bonds, which will lead to overall lower portfolio yields—a so-called greenium. Currently there’s no premium in the municipal bond market, and little to no premium in the corporate bond market, for green versus nongreen bonds from the same issuer. For example, a large public university in Arizona recently brought a taxable deal to the market to fund various projects at the school, offering a green bond tranche earmarked for environmentally beneficial uses and a nongreen tranche for general purposes. Bonds in the same maturities in both the green and nongreen tranches were priced at the same yields. Similarly, the State of Connecticut recently issued tax-exempt bonds with two series labeled social bonds, while another two series were unlabeled and earmarked for general purposes. The social bonds were priced at equivalent yields to the conventional unlabeled bonds. The yield of ESG portfolios will be similar to that of traditional portfolios, and investors don‘t have to give up any yield in their portfolios to implement an ESG strategy in today’s market environment. This also presents an opportunity for future outperformance, since demand for labeled ESG bonds is poised to grow over time, and today’s ESG investors can invest in green or social bonds with no premium priced in.
By incorporating ESG factors into the investment process, we believe investors can actually improve long-term returns. ESG integration is becoming an increasingly important component of the investment process for investors who are concerned about long-term risk mitigation. By considering ESG risks in fundamental credit analysis, investors can avoid issues that could potentially underperform the market over time.
How green are green bonds, anyway?
Green bonds are defined as bond issues that fund projects with a positive environmental or climate-related purpose. The Green Bond Principles (GBP), developed by the International Capital Market Association, seek to provide bond issuers with guidelines for issuing a green bond, including continued emphasis on transparency and disclosure around tracking the use of proceeds for these environmental projects. The GBP seek to provide clarity for all stakeholders involved in the issuance and investing of these bonds to ensure the integrity of the green bond market as it continues to develop and grow.
One concern that investors have about green bonds in particular is the concept of greenwashing, or the idea that a bond issuer might falsify or exaggerate claims that they’re funding environmentally beneficial projects. Although bond issuers can self-label their bond issues as green, greenwashing isn’t very common in the green bond market; we’ve found very few bond issues with unsubstantiated pro-environmental claims. It’s still important, however, for investment managers to provide ongoing internal due diligence by tracking the use of proceeds for these bonds to ensure they continue to provide positive environmental benefits.
Companies and municipalities are permitted to issue green bonds even if the entity fails ESG criteria at the organizational level. Green bonds are characterized by the use of proceeds for each individual bond issue, which means a company could potentially issue bonds labeled as green if the proceeds will be used to fund an environmentally beneficial project, even if the company itself fails responsible investing criteria. Depending on an ESG investor’s unique guidelines, they may not buy a green bond if the company or municipality itself has detrimental social or environmental practices. For example, an investor could pass on a health care organization’s green bond issue to finance a LEED-certified hospital building due to significant governance problems, including very low ratings for quality of patient care.