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.
How does investor engagement work in fixed income?
Engagement is an important component of responsible investing, and it differs in the equity and fixed income markets. Engagement on the equity side is achieved through proxy voting, but bondholders don’t have the same ability to vote as stockholders. However, engagement is growing in momentum in the fixed income markets. Bondholders do have the ability to engage in direct communication and open dialogue with these entities. Parametric joined the Sustainable Accounting Standards Board (SASB) Alliance in early 2021, and we plan to use engagement to encourage companies and municipalities to use the SASB framework to disclose material ESG metrics.
A great example of successful bondholder engagement in the municipal market was the recent CoreCivic private prison deal to finance two new correctional facilities in the state of Alabama through the taxable municipal bond market. As awareness grows around the injustices of mass incarceration and the glaring conflict of interest in the very profitable private prison industry, financial institutions face more pressure to refrain from providing financing or support for these types of bond deals. After activist municipal investors joined business leaders and sustainable business councils to write letters to the large banks that were to underwrite the deals, the financing eventually fell through. This is an example of fixed income investors using engagement to draw attention to social justice issues and influence positive societal change.
Most municipal bonds are considered responsible, so why use a responsible investing strategy?
The municipal bond market provides financing to vital projects and entities that serve local communities, from school buildings to nonprofit hospitals to transportation systems. While most municipal bond issues don’t have negative ESG attributes, there are some bond issues that investors and ESG framework builders typically exclude from a responsible investment portfolio. Examples include:
- Public utilities that generate power from fossil fuels
- Transportation projects that contribute to higher carbon emissions, such as airports and toll roads
- Correctional facilities
- Tobacco or liquor tax bonds
- Gaming or casino bonds
- Issuers with reports of ongoing discriminatory practices or consent decrees
The bottom line
ESG investing is relatively newer to fixed income strategies. It’s understandable that investors have questions and concerns about this growing segment of the market. However, we believe investors can align their values with their fixed income portfolios without sacrificing financial performance or deepening long-term risks.