A five-minute guide to investing in sustainable bonds

In recent years, environmental, social and governance (ESG) factors have become a big topic in terms of our investments.

But much of the conversation has been in terms of equity investing, with investors concentrating on the shares of companies that are doing something to help the planet and its inhabitants.

Less has been said about bonds – loans to companies and governments so that they can finance this work – even though this market is growing rapidly.

Opportunities for investment

As the chart below shows, we have seen a significant surge in sustainable bonds in recent years. But 2021 saw significant growth in the market for green and sustainable bonds, driven by regulation, environmental targets and increasing investor demand.

New research from Pictet and the Institute of International Finance also suggests that global issuance of ESG bonds could reach $4.5 trillion a year by 2025, with fixed income markets needed to help raise some of the $4 trillion of capital required annually just to contain the threat of climate change.

What are green bonds?

Green bonds are loans which are ring-fenced by a company or a government for new and existing projects which deliver environmental benefits. This could include a utility company issuing a bond to increase its renewables capacity, or a bus company looking to move to electric vehicles, for example.

Ian Buckle, who co-manages the Aegon Ethical Cautious Managed fund, said: “The green bond market has been around for some years but was historically dominated by a small handful of sectors like utilities. Now it’s much more diverse with most sectors represented, which helps in terms of diversification.”

Investors should be aware, however, that although the proceeds are used for green projects, the firm itself may not be ‘green’. So, it’s up to the individual whether they invest. “A pharmaceutical company may issue a green bond to help make its buildings more energy efficient, but if it is still testing on animals, we wouldn’t invest,” is an example given by Bryn Jones, co-manager of Rathbone Ethical Bond fund.

Jonathan Owen, who is co-manager of a sustainable version of the Elite Rated TwentyFour Absolute Return Credit fund added: “I have a slight issue that you can be a dirty business but can do a green thing on the side and benefit from cheaper financing. So, as an investor, when we look at ESG bonds, we look at what the business is doing as a whole. We’re more concerned with the overall direction of the business than one specific asset.”

What are blue bonds?

Blue bonds are used to finance ocean-related conservation projects. The money raised is directed to specific projects, such as protecting marine ecosystems and promoting better fishing practices will help economies to be more resilient. This is important for the environment, but they also have a social aspect as protecting coastlines and ecosystems also ensures jobs are protected in the tourism and hospitality industries, for example.

However, the issuance of blue bonds has so far been minimal. The Seychelles launched the world’s first sovereign blue bond in 2018, for example. And there are some in Australia linked to the coral reef. But this area of the market is still finding its feet.

According to Noelle Cazalis, co-manager of Rathbone Ethical Bond fund, the blue economy is valued at €1.3 trillion. “You can see how these instruments are crucial to tackle the challenges raised by the UN Sustainability Development Goal 14 ‘Life Below Water’,” she said. “As ethical investors, we are constantly seeking for investment opportunities but, so far, they are very scarce.”

What are social bonds?

Social bonds are a means of helping to finance solutions to social problems such as youth unemployment, long-term health issues and homelessness. These bonds have been around for some time. For example, in the early 19th century, there was a lot of lending around railways and sewage in London. But the sector really took off during the Covid pandemic, when investors became more cognisant of social concerns like health and welfare.

In April 2020, Guatemala became the first country to issue a sovereign social bond aimed at financing COVID-19 response efforts, for example. Corporate social bond issuance is on the rise. With consumers now more attuned to social issues, social bonds provide companies with an instrument to demonstrate support for their wider stakeholders, from employees to customers and local communities.

What are sustainability-linked bonds?

These bonds are not ring-fenced for green or sustainable purposes. Instead, issuers are committing to improvements in sustainable outcomes within a predetermined timeline. And, if they fail to achieve their pledges, they have to pay investors more as a penalty. For example, retailers such as Tesco and H&M have issued these bonds with targets such as reducing carbon intensity, increased recycling of textile materials and cutting food waste.

In terms of benefits, these bonds provide an opportunity for companies in sectors that are challenged from an ESG standpoint, but which want to make improvements. As such, they are currently experiencing the highest growth rates.

“You also don’t need to be a big company to issue a sustainability-linked bond,” added Jonathan Owen. “A small business with good ESG and a strong plan to reduce emissions could do so too and, at the same time, tap into slightly cheaper finance. I’d like to see this area grow more but this year, given where financial markets are, there has been a pullback in issuance.

As for disadvantages, several professional investors have said that the penalties are not large enough to incentivise the issuers to meet their targets.

Kenny Watson, co-manager of Liontrust Monthly Income Bond commented. “While far from perfect, the rapid growth in sustainable linked bonds is a positive development for ESG, as it broadens the issuer base by company and by industry, allowing a wider spectrum of companies to demonstrate their increasing commitment to improve their sustainable and environmental metrics,” he said.

“We would like to see further developments in terms of more challenging targets and meaningful penalties and continue to question whether these targets are incorporated into executive performance measures. Overall, while there are opportunities in this space, we stress that our sustainability assessment remains on companies as a whole and not just individual bond issues.”

Iain Buckle added: “This is the area most prone to greenwashing in my view. It’s an interesting asset class, particularly for those sectors that don’t naturally lend themselves to green bonds. But often the increase is not penalising enough. O.25% is not a financial incentive and targets may not be stretching.

The impact of inflation and rising rates

While ESG bonds have their own characteristics, investors do need to know that there is no difference between them and conventional bonds in the way they behave in an economic cycle.

The risk profile is still driven by the underlying credit quality of the issuer (the company’s ability to make the income payments and pay back the loan) and they are impacted by inflation and rising interest rates.

Jeremy Wharton, co-manager of SVS Church House Tenax Absolute Return Strategies commented: “We have several holdings, but don’t really invest in them purely for their ESG credentials – more because we like the credit behind them.

“Most of our investments also tend to be secured issuance higher up the capital structure, but not all of them – we bought a subordinated bond from a wind generator company, for example.

“Last year there was a lot of good issuance, but it came at the wrong moment in the rate and credit cycle. For example, Berkeley, the housebuilder, issued a 10-year bond at 3.5% at an issue price of 99.38. It is now trading at 81, so we are more a buyer of that bond now as it has gone down.

“There’s an opportunity now to buy these bonds at better value and they will be much more rewarding for investors than they were.”

“Bonds have had a tough start to the year, but now we’re in a position where yields are more attractive,” agreed Bryn Jones. “The valuation of investment grade securities suggests that they are pricing in the worst-case scenario since the 1970s. 6% of the European investment grade market is priced to default, for example, when the average is 1%. I think we’re now being compensated for taking some extra risk.

“It may be a little early to be coming back in as yields could go higher and there is the possibility of recession, but very soon it could be a good opportunity to buy.”