The lion’s share of attention in sustainable investing hasn’t been directed towards instruments representing the most profound investment paradigm shift, one that promises to permanently alter the landscape of capital markets themselves. That is: the rise of sustainable bonds. Here we will explore what sustainable bonds are, why they matter and what you should consider before adding them to an investment portfolio.

What Are Sustainable Bonds? A simple yet effective definition of a sustainable bond is that it offers investors information about the issuer’s proceeds through the bond issuance. SBs differ from their rapidly growing cousins, green bonds, in that they offer issuers a broader mandate of acceptable environmental, social, and governance uses for the proceeds of the bond, as opposed to the narrower environmental concerns of green bonds. In other words, within the scope of responsible investing, a green bond focuses solely on the “E” component while a sustainable bond incorporates both the “E” as well as attending to the “S” attributes of the company’s operations and capital deployment.

Most attention regarding improved ESG and corporate social responsibility (CSR) considerations by corporate entities has been focused on equity shareholder interests and a company’s associated enterprise value. This is particularly interesting considering that the debt markets have now become the principal source of external financing for U.S. firms, dwarfing equity issuances in recent years.

Since 2006, new corporate bond issuances have exceeded new issuances of equity more than eight-fold. This increase also translates to the number of such companies that use primary bond markets: from about 1,250 before the 2007 debt crisis to more than 2,500 today. One longer term trend of significance is that bond financing is less expensive than equity financing and is likely to remain so, at least in the foreseeable future.

As investor concerns with ESG gradually catch up with the most prolific investment instrument available to them (bonds), companies will increasingly need to reorient their offerings to satisfy these values. As these parties come into alignment and ESG becomes increasingly mainstream, we will witness perhaps the most significant change to capital markets in a generation. Investors and corporations alike should heed this development.

Why Do Sustainable Bonds Matter? Articulating the business case for SBs requires a brief examination of several factors covering multiple self-motivating interests of various groups. Ultimately, the greatest value of a dedicated sustainable or green bond is what management sometimes overtly communicates through the adage, “Put your money where your mouth is.”

The intrinsic value of sustainable/green bonds is multi-fold. SBs prioritize the importance of issuers explicitly taking into consideration externalities, such as the environment and their environmental footprint, as a means of either reducing risks or forming a competitive advantage through improvement in efficiencies. They also help investors have a clearer understanding of management’s priorities and business practices.

Here are a few examples of such considerations:

Intangible Value. As economic records have been broken with the ascent in the market’s valuation, the underlying asset that truly garners this meteoric rise is the value that investors and consumers place on intangibles.

Intangible assets — rather than hard, physical assets — have been the transformative driver of economic value for the past several decades. As can be seen in “Components of S&P 500 Market Value,” the largest and most meaningful ingredient of economic currency has been the rise in the value of intangible assets.

Senior corporate managers have become attuned to investors’ increasing interest in placing value on their company’s intangibles. At the same time, protecting the firm’s reputation and, ultimately, its enterprise value has become a paramount concern to managers. Those management teams that are not as vigilant in protecting their brand identity have suffered mightily for their lack of attention. The names are familiar: Enron, Equifax, VW, and Wells Fargo have all suffered the financial impact from reputational damage, and their investors have paid the price along the way.

Corporate Priorities. It is critical to understand how management thinks about the company’s brand and addresses material risks, as much of an enterprise’s value may depend on the assessed value of its intangible assets. This understanding requires a set of questions that go beyond a financial review. Consideration of the company’s ESG practices aims to help uncover and ascertain factors that may inhibit financial performance. Observing management’s willingness and ability to proactively manage these ESG factors not only reduces credit risk, it also creates the potential for firms to form a competitive advantage.

One of the best ways to understand management’s priorities and processes in addressing material risks is through the CSR report. A broad 2014 meta-study by Oxford University reviewed 190 of the highest quality academic studies conducted on the relationship between sustainability and firm performance. Overall, the study made a strong case for business investment in sustainability, drawing these key conclusions from the body of studies they reviewed:

• 90% showed that sound sustainability standards lowered the cost of capital; • 80% showed a positive relationship between stock performance and good sustainability practices; • 88% indicated that operational performance of firms was improved by robust ESG practices. Additionally, studies show that companies employing favorable CSR attributes have improved customer engagement, forming greater consumer loyalty and better corporate profitability.

Risk and performance. Corporate behavior matters more than ever. When evaluating sustainable investments, most of the attention focuses on performance impairment related to additional fees, qualifying as an ESG investment, or supposed limitations of a sustainable or green issue. The costs of not paying attention to sustainable issues has the potential to be much greater to investors who hold the wrong companies, and may even pose existential risks to an enterprise. Sustainable bonds provide investors with more information than ever on how corporate management teams view some of the greatest risks to enterprise value, including intangibles like reputation and supply chain shocks that may create havoc on a company’s value.

What to Consider When Incorporating SBs into a Portfolio Investors can ask questions to understand how their fixed income fund managers approach ESG considerations within their investment process, especially when it comes to protecting the interests of their investors. Some examples:

• Does the fund company or portfolio manager recognize the importance of incorporating ESG in their investment process? • Does the portfolio manager articulate the details about incorporating ESG in the investment process and offer specific examples? • Does the fund company or the portfolio manager explain how the ESG approach is used to uncover potential risks as part of their investment process? • If the fund invests in industries that are characteristically known to have higher ESG risks, such as resource extraction industries or the utility sector, does the portfolio manager articulate how the ESG lens is applied to these investments? • Does the fund company or the portfolio manager produce an annual impact report communicating how they are addressing ESG considerations in their investment process? • Is the fund company a signatory to the United Nations for Principles for Responsible Investment? • How does Morningstar rate the fund on its ESG characteristics (i.e., how many “globes” does it assign to the fund)?

Patrick Drum serves as portfolio manager of Saturna Sustainable Bond Fund, and heads up ESG credit research for Saturna Capital, which is based in Bellingham, Washington. Patrick also served as the chair of the United Nation’s Principles for Responsible Investment subcommittee on fixed income. He holds a BA in economics from Western Washington University and an MBA from Seattle University Albers School of Business.