Over the past five years, investors and advisers alike will have become very used to the term “ESG”.

A shorthand for environmental, social and governance investing (a strand of investing where you take into account these factors when deciding where - and where not to - put your cash), the style has boomed in recent years.

In 2022, investors pumped £100mn a week into ESG and, as they are more commonly becoming known, sustainable funds.

But while discourse around the type of company that ESG investors should be adding or removing from their stocks and shares portfolios has become commonplace, the role that fixed income can play in an ESG-focused portfolio is less well known — despite the fact that bond investors say that sustainability considerations are vital to a company or state’s creditworthiness.

So, how can you look to create an ESG-friendly bond portfolio, what are the advantages and the risks, and how should you assess different fixed income investments?

This guide will explore the opportunities in the bond market for ESG investors, and comes with an indicative 30 minutes of CPD.

The case for fixed income

While bond investors may not be able to vote at shareholder meetings the same way equity investors can, this does not mean that investing in fixed income through an ESG lens is less fruitful.

“They can actively engage with corporates and sovereigns to give feedback on existing issues, to impart views and share best practice in the case of new issuances,” says Véronique Chapplow, ESG investment specialist at T Rowe Price.

According to Kenny Watson, investment manager of Liontrust’s Sustainable Investment team, businesses were becoming more willing to listen and engage with bondholders on ESG matters.

In fact, Stephen Metcalf, head of sustainable investing for RBC Wealth Management in the British Isles and Asia, points out that large, fixed income managers often get better access to senior executives who they can engage with on ESG issues.

While equity investors may speak to the investor relations team, for example, large bond investors may speak with the chief financial officer.

Global fixed income markets are also significantly larger than equity markets, so fixed income investing can open the door to a huge part of the investable universe that is suitable for ESG investors, but not available to equity investors.

Bethan Dixon, portfolio manager at Quilter, says: “There is a greater number of companies to get exposure to – those that are listed, and those that are private.

“This provides a great opportunity when seeking investments that can’t be accessed in equity markets but are positively contributing to environmental or social challenges.

"For example, fixed income investors can invest in housing associations, which provide a positive social outcome through the provision of housing to low income sectors.”

Fixed income investors can also opt for targeted bonds, such as green bonds, social bonds, transition bonds, sustainable bonds or blue bonds, to fund specific projects. Metcalf says these so-called “labelled” bonds could, for example, allow investors to directly finance a company’s emissions reduction.

“These types of instruments are arguably the most impactful of publicly traded securities, as they provide a level that general ownership struggles to achieve,” he adds.

Looking at companies or states through an ESG lens can also identify those that are more positioned for long-term success, and therefore those that will be able to repay their debt, experts say.

Fatima Luis, senior portfolio manager at Mirabaud Asset Management, says: “A business that is seen to be engaging in environmentally damaging operations without mitigating or considering ESG factors into their business strategy may struggle to access affordable capital.

“In extreme cases, not considering these risks could lead to bankruptcy, as it did for frequent borrower Pacific Gas and Electric. After the devastating wildfires in California were caused by the company’s faulty equipment, a massive fine led to the company’s default.”

Lyndon Man, co-head of global investment grade credit at Invesco, agrees. He says that using ESG in the investment process was necessary, because most “negative credit events” had their roots in poor governance structures or environmental or social practices.

“If you're not paying attention to those ESG factors, you’re not doing your job properly,” Man says.

Understanding labels

As with all ESG investing, problems surrounding disclosure, a lack of data and greenwashing – where an investment product is advertised as 'greener' than it is – can cause issues for investors.

This is particularly the case for 'labelled' bonds, where the funds raised are supposed to be used for a specific purpose.

Chappow says: “The main risk is greenwashing in the labelled bond part of the market. Certain bonds can lack credibility or meaningful targets.”

While there are widely-used standards in the space, such as the International Capital Market Association’s Green Bond principles, they are voluntary and may not even line up with your client’s views on a particular subject.

“This is especially true for some of the newer types of products, such as blue bonds for the protection of maritime ecosystems or sustainable development bonds, where standards are even more diverse,” says Metcalf. “As always, the devil is in the details and thorough due diligence is often the only answer.”

A key risk with the type of ESG bonds where the proceeds are supposed to be used for a specific purpose is if the project or activity being financed does not deliver the outcomes, or does not provide adequate reporting to the investor to determine the outcomes.

Dixon notes this was a larger issue for sovereign bond investors. She says: “Governments are primarily focused on satisfying the electorate and other stakeholders, rather than bondholders.”

It is also worth noting the wider risks to a portfolio that is tailored for ESG factors, such as an unintended tilt that could limit your financial gains at certain points in the market.

For example, Man points out that if you exclude energy stocks because of a stance against fossil fuels, your investments would likely underperform if oil prices rallied, as happened in 2022.

Jenny Mills, portfolio manager at BRI Wealth Management, says: “The risk with positive screening is that you end up incorporating those best performers in certain areas of ESG, but may not incorporate other areas that ESG investors are looking for.

“Another risk is that those companies with a low ESG score, and therefore not included in your portfolio, are those on a ‘transitioning journey’ and their potential could be overlooked.”

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