There’s no doubt that more investors are voting with their principals these days. Environmental, Social and Governance (ESG) and Socially Responsible Investing (SRI) styles of investing continue to gather billions in assets as investors incorporate ESG metrics into their portfolios. However, much of that asset gathering has been on the equity side of the equation. Applying ESG criteria to stocks seems to be where most investors are trending.
But stocks aren’t the only place where ESG/SRI can thrive. In fact, the other side could be better.
Applying ESG metrics to bonds and fixed income can provide investors with many benefits – and it looks like investors may finally be getting the hint.
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Stocks Rule in ESG Assets
According to the latest Forum for Sustainable and Responsible Investment (USSIF) report on U.S. Sustainable and Impact Investing Trends, one out of every three dollars under professional management in the United States (or about $17.1 trillion) was managed using ESG/SRI techniques. Looking deeper into USSIF’s data, the vast bulk of those funds were domiciled in equity investments. And it’s easy to understand why.
ESG as an investment style began on the equity side of the equation. The early days of ESG simply meant removing certain stocks – like tobacco, fossil fuels and weapons’ producers – from the larger indices. Building on this head start, index providers and other managers developed rules to garner ESG metrics. From there, institutional investors used these new standards.
Meanwhile, retail investors have been quick to adopt ESG for their portfolios. Truth be told, it’s easy for people to extrapolate – at least on a surface level – that Exxon (XOM) equals “bad,” whereas First Solar (FSLR) equals “good.” This makes it easier to buy and sell stocks within an ESG framework.
As a result, money has flowed into the equity side of the ESG equation.
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ESG for Bonds
However, it looks like investors are finally starting to see the merits of ESG when it comes to fixed income investing. According to data compiled by Bloomberg, new issuances of ESG-focused bonds from corporations and governments have already clocked in at $575 billion so far this year. That’s $100 billion more than all of 2020’s issuances. All in all, ESG-focused bonds hit $1 trillion for the first time ever this year.
Those ESG bonds come in four major forms: Green bonds, Social bonds, Sustainability bonds and KPI-Linked bonds.
- Green Bonds, which are the largest issuance, are the simplest to understand. Here, bonds are issued directly to fund the improvement of the environment or to fund a specific “green” project like a solar or wind farm.
- Social Bonds are similar to Green bonds in that they are used to fund a specific project. This time, however, the focus is on projects designed to benefit society. For example, new construction for communal benefit or a hospital serving a low-income area.
- Sustainability Bonds can be thought of as a combination of both Social and Green bonds, and are used to fund mixed use projects with clear environmental and societal goals.
- KPI-Linked Bonds is the newest category of ESG bonds that are issued by corporations for general purposes. The kicker is that these bonds are tied to internal metrics that the firm must hit or face penalties to its bondholders like higher coupon rates. Often these bonds are issued by “dirty” industries like coal that are looking at cleaner practices to improve their environmental/social standings.
In addition to the actual insurance of SRI-focused bonds, many ratings firms are starting to apply ESG metrics directly to their credit analysis. Both Moody’s and Standard & Poor’s have started to seriously look at ESG metrics on corporate bond issuers that showcase environmental and social risk.
Meanwhile, the United Nations through its Principles for Responsible Investment (PRI) unveiled a new ESG credit ratings framework. More than 160 institutional investors, as well as over 20 credit ratings agencies, signed the UN’s PRI pledge.
Explore our Fixed Income Channel to learn more about incorporating this asset class in your portfolios.
Benefits for Investors
All of this ESG focus on the fixed income side can reward investors with serious benefits. Just like with stocks, investors now have the ability to create a total portfolio designed around ESG. Before, you could have a green equity side, but also have a “dirty” bond side. For many investors, this simply wasn’t acceptable. Investors now have the ability to build a portfolio that aligns with their morals.
There’s evidence that green bonds may be able to outperform just like ESG equities do.
For one thing, by applying ESG metrics to a firm’s credit rating, investors can potentially unearth problems that were hidden before. For example, how does climate change impact a firm’s future ability to generate cash flows? An insurance company may seem strong today, but what will the increase in wildfire activity do to its bottom line down the road? How will doing business in a less free nation impact a consumer products manufacturer’s production and cash flows? Answering these sorts of questions can provide strong fixed income opportunities and better returns for investors.
And there’s some evidence to suggest just that.
A report by Barclay’s showed that firms with high ESG scores had marginally higher credit ratings than those with low ESG scores in its parent Bloomberg Barclays U.S. Corporate IG Index. Additionally, Barclay’s found that high ESG bonds managed to have cumulative outperformance of around 2% over the last seven years. Given the low interest rate environment and generally low returns with fixed income to begin with, the extra outperformance is impressive. S&P Global found a similar return profile when looking at high-yield or junk bonds with high ESG scores.
The Bottom Line
ESG has long been a stock-focused investment style. However, it’s very suited to bonds as well. With new issuances and credit ratings agencies now adding ESG to their research, investors should be able to benefit over the long haul.
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