Roughly 25% of all investable assets globally, or more than $23 trillion, is invested in impact or environmental, social and governance products today. Most of this is invested on the equity side, as the fixed income ESG area is still nascent — for now.

In fact, according to Cornerstone Capital Group, only $385 billion has been allocated to fixed income ESG investing. Further, most “green bond” issuances fall into the $10 million to $100 million bracket. And there’s only a limited number of issuers of sustainable bonds. ESG equity funds, according to an MSCI analysis, outnumber ESG fixed income funds 3 to 1 globally and 4 to 1 in the United States.

That said, Cornerstone equity strategist Michael Geraghty believes fixed income ESG is an area advisors should counsel their clients on, especially those who want to spread impact investing throughout their portfolio.

“This is a relatively new and unexplored area,” Geraghty told ThinkAdvisor. “Quite a bit has been written about how asset managers use ESG in fixed income portfolios, but very little has been written on how asset owners or clients can incorporate ESG into fixed income portfolios.”

Cornerstone’s research paper, “Considering ESG Factors in Fixed Income Investing,” written by Geraghty; Craig Metrick, head of institutional consulting; and Jennifer Leonard, director of asset manager due dilligence, provides an overview of this “complex” market, and how investors can take advantage of it for ESG investing.

However, Geraghty warns, “It is different from equities. There are a number of ways in fixed income to invest, but it’s a new area with new products. Interested investors should speak to their investment advisor before jumping in.”

More Fixed Income in Portfolios?

There are three key reasons investors should incorporate ESG into the fixed income allocation of their portfolio, according to the paper: values alignment, investing for quantifiable impact, and achieving risk-adjusted returns. Some products such as green bonds may achieve all three of these objectives, although the authors state these factors are not mutually exclusive.

The paper focuses on debt instruments backed by both public (e.g. government and municipalities, supranational development financial institutions) and private (e.g. corporate) issuers. “There are a growing number of opportunities for asset owners to invest in fixed income vehicles and securities that provide funding for impactful projects or sustainable companies, and that offer competitive yields,” the authors state.

Geraghty made clear that fixed income ESG investors, at least for now, typically are interested in a having a quantifiable impact with their investment. “A fixed income investor is in fact making a loan, and so a lender can demand to know how their loan is doing,” he says. “For example, if one supports financing a solar facility, they can measure impact of loans on amount of energy generated or reduction of emissions. So one particular appeal of fixed income ESG investing is quantifiable impact.”

There are five major areas of sustainable bonds, especially from public issuers:

  • Green bonds: raise capital for dedicated environment benefits; dominates the sustainable bonds sector;
  • Social bonds: raise capital for projects with dedicated social benefits, such as affordable water, sanitation and transport for underserved communities;
  • Sustainability bonds: raise capital for projects with both social and environmental benefits, such as building public sector energy-efficient buildings;
  • Social impact bonds: “Pay for performance” or “pay for success” bonds that typically finance a pilot project, for example, for the homeless or programs to reduce recidivism;
  • Corporate bonds: Not specific for projects, and “green” based on the investment manager’s own criteria.

Investors have several vehicles in which to invest, including sustainable bond funds, fixed income notes, private debt funds and Community Development Financial Institutions.

One key challenge with fixed income ESG, and green bonds in particular, is how to measure them and what they actually offer. The International Capital Market Association’s Green Bond Principles, and the Climate Bond Initiative’s Climate Bond Standard” are used as guidelines to determine whether or not a bond qualifies as “green,” but Geraghty says it’s not like S&P or MSCI saying “categorically they are four-star green bonds.”

He provides an example of the Spanish energy company Repsol issuing a green bond in May 2017 that it planned to use to save 1.2 million tons per year of carbon dioxide by improving the efficiency of its fossil-fuel burning activities. “But give me a break, Repsol issuing a green bond? If an investor sees that in a green bond portfolio, they may [want to] call that into question.”

In other words, read the fine print.

However, there are many positive options. Fixed income ESG allow investors to get involved with municipal projects that may help local welfare. For example, Massachusetts issued the first municipal green bond to “finance projects with net positive environmental impacts,” according to the report.

Some corporate bond issuers have been screened using ESG criteria by having good relationships with their unions. Starbucks issued the first-ever U.S. corporate sustainability bond in 2016 in which it raised $500 million that was dedicated to sourcing coffee that meets the company’s standards to measure environmental and social practices of its suppliers.

Geraghty also notes that fixed income is typically are buy and hold. “The attraction of these vehicles is you can track and measure the impact of your investment,” he says. “People we deal with aren’t in it for the quick buck. They are impact investing. They want to make a difference.”

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