Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S. (Photographer: Michael Nagle/Bloomberg)  

How to Build a Sustainable Bond Portfolio

(Bloomberg Markets) -- Wall Street’s do-good investment boom is finally taking notice of the credit markets. Sustainable investment assets grew 37 percent last year, according to Bloomberg data, but the majority of those funds focus on stocks. That’s leading to some awkward conversations on Wall Street, as wealthy investors and foundations increasingly want to align their entire portfolios with their social mission but are finding few opportunities to do so in fixed income.

“Most of the people who are interested in incorporating ESG are interested in doing so throughout their portfolio,” says Rui de Figueiredo, co-head and chief investment officer of the Solutions and Multi-Asset Group at Morgan Stanley Investment Management. Yet, with a dearth of available fixed-income products categorized as environmental, social, and governance, those investors haven’t looked at it much. “But that creates more demand on the part of asset managers to create those opportunities,” he says.

Of almost 1,900 ESG funds tracked by Bloomberg, 15 percent invest in fixed income, vs. 62 percent in equity. On an asset basis, that figure is even smaller, with fixed income representing about 3 percent of the $491 billion invested in such funds. 

How to Build a Sustainable Bond Portfolio

Bonds, though, have the potential to be a popular ESG asset class for impact investors, those who look to generate environmental and social outcomes along with financial return. Fixed income typically attracts investors with longer time horizons who might be more philosophically aligned with environmental and social issues, says Mike Amey, head of sterling portfolio management and ESG strategies at Pimco Investment Management Co. A World Bank report released in April details some initial evidence that ESG factors can help bond investors avoid default risk.

To fill the gap, asset managers are looking at the existing debt market with fresh eyes, tapping into potentially overlooked asset classes such as affordable housing and development bank debt to find investable opportunities for sustainability-hungry clients. They’re also trying to build infrastructure, such as benchmarks, that will support greater liquidity and investment levels in these products.

Here’s what’s going into sustainable bond portfolios.

DEVELOPMENT BANK DEBT. High-grade debt issued by the World Bank and other development banks offers some of the best-­performing do-good credit on the market, according to UBS Group AG, which found the debt delivered strong returns for its socially conscious private bank clients. “We weren’t asking clients to forgo any expected returns,” says Simon Smiles, chief investment officer for ultra-high-net-worth clients at UBS’s wealth-management division. Development bank debt turned out to have “a very attractive expected risk-return over a cycle for AAA-rated debt,” he says. That performance encouraged Solactive AG, a German provider of indexes, and UBS to create in April a development bank bond index family to make the debt more accessible for investors. 

How to Build a Sustainable Bond Portfolio

GREEN BONDS. The market for environmentally friendly bonds is expected to hit a record $170 billion in new issuance this year, but the bonds are in relatively short supply, according to Bloomberg NEF. Green bonds represent less than 0.5 percent of the global fixed-income market. Most deals are oversubscribed, and their environmental credentials appeal to long-term investors who buy and hold investments. If you can get your hands on a green bond, you’ll find the sector has been dominated this year by sovereign, local government, and financial issuers, which use the proceeds to fund smaller projects focused on renewable energy, green buildings, sustainable water management, and the like.

Social and sustainability bonds, which concentrate on themes such as responsible farming or housing finance, are also a budding area, with about 25 deals this year. But there are only about 110 bonds on the market, representing a total issuance of about $47 billion, according to data compiled by Bloomberg.

MUNI BONDS. The municipal bond market is an “abundant source of potential investments” in ESG, says James Iselin, head of the municipal fixed-income team at Neuberger Berman Group LLC. The asset manager recently retooled the focus of an existing $56 million muni fund to center on impact investing. Debt issued by local communities can have a positive effect, funding energy and water-treatment projects, schools, and public transportation; it can also help investors lower their tax liabilities. Eaton Vance’s Calvert Research and Management, AllianceBernstein, and Columbia Threadneedle Investments have also launched municipal funds with similar do-good mandates. 

ESG-RATED BOND PORTFOLIOS. Fund managers such as Pimco, Fidelity Investments, and Brown Advisory Inc. are building their sustainable fixed-income funds by selecting bonds issued by companies that perform well on ESG ratings maintained by third parties such as Sustainalytics and MSCI Inc. This essentially replicates the most common ESG equity strategies in the debt market.

“It’s still fairly early days, but we thought this was an important building block,” says Colby Penzone, head of investment product for Fidelity Investments, which launched a sustainability bond index fund in June. For socially conscious investors, “the preference in the marketplace to date has been more concentrated in the equity space, but a diversified portfolio has to have fixed income,” he says.

REAL ESTATE. When the Ford Foundation last year committed $1 ­billion from its endowment to impact investing, it said one of its top initial investment targets would be affordable housing. Community Capital Management Inc., an impact investing company that oversees about $2.3 billion, slices up portfolios so investors can use their fixed-income strategies to support housing in a number of categories such as disaster recovery, minority neighborhoods, arts and culture programs, and sustainable agriculture. The Florida-based company last year created a pool of mortgage-backed loans, municipal debt, and other asset-backed debt tied to affordable housing for women and girls. They built the product in response to clients who asked about investing in gender-focused products. “We’re able to know we’re helping low- to moderate-income women specifically get access to capital to buy a home,” says Andy Kaufman, a senior portfolio manager at Community Capital Management Inc. 

Environmentally friendly buildings are also presenting opportunities. Federal National Mortgage Association, for example, was the largest issuer of green bonds in the world last year, selling more than $27.6 billion in green mortgage-backed securities in 2017, up from $3.6 billion in 2016. The U.S. government-backed firm, which guarantees housing-­related debt, built the securities by pooling financing for green-certified apartment buildings. The water and energy efficiency modifications made to the properties in those portfolios will likely reduce utility bills, according to Fannie Mae. That means those buildings will have “greater net operating income and a greater ability to repay their loans,” says Chrissa Pagitsas, director of green financing for Fannie Mae.

CDFIs. Community development financial institutions, which provide affordable lending to low-income and underserved communities, are gaining traction with impact investors. Banks have been the primary investor in the area for years, thanks to the 1977 Community Reinvestment Act, which encouraged commercial banks to meet the lending needs of their local communities. This has given CDFIs a long performance history. Some are even large enough to have credit ratings, which makes them appealing to retail investors, according to Louise Herrle, a managing director at Incapital LLC, an underwriter and distributor of fixed-income securities to broker-dealers and financial advisers. “They’ve been in the market for quite a long time, so people have a comfort level with them,” Herrle says. CDFIs are also courting impact investors, allowing them to raise more capital so they can expand, she says.

Chasan is a sustainable finance editor at Bloomberg News in New York, with Amanda Albright, Julia Nikulski, and Dimitris Gogos.

©2018 Bloomberg L.P.