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Investing in bonds – why ESG matters

We look at the importance of environmental, social and governance (ESG) factors when investing in bonds.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

A common misconception is that analysing environmental, social and governance factors (ESG) is only relevant when investing in shares. But that’s not the case – they can be important to bond investors too. In 2021, the value of labelled bonds issued exceeded $1trn for the first time. ‘Labelled’ covers bonds categorised as green, social, sustainable or sustainability linked.

The return potential of a bond investment is capped at the return of the amount loaned plus any interest payments. That’s why ESG analysis in fixed income is often focused on downside protection. The downside is the potential to lose the money invested, and bond fund managers don’t want to lend money to an issuer that defaults.

This isn’t personal advice. If you’re not sure what’s right for your circumstances, ask for financial advice. Remember all investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Materiality – what’s important and why?

Each bond issuer, whether a company or a government, will have different ESG factors for investors to consider. And not all of these factors will be equally important. This is where materiality comes in.

Companies often issue debt over lots of maturity dates so it won’t all need to be repaid at the same time. For example, some debt could need to be repaid in ten years and some in 20 years. Why is this important? Well, potential investors need to consider all of the factors that might affect a bonds value over its lifetime.

In the short term, some factors might be likely to have little or no impact at all. But over the longer term, factors like the level of fuel consumption and proportion of electric vehicles are likely to have a direct impact on costs for a logistics company. So the key is to identify which issues could affect the financial performance of the business, what the impact could be and whether this risk is reflected in the price.

Improvement through engagement

While bond investors can’t vote on company proposals like shareholders can, they can still engage with company management. This could be to press for improved disclosure of information on a topic, or a change in the way a company does something. And as providers of capital through their bond holdings, their voice matters.

If companies want to issue debt in the future to fund their growth plans for example, they’ll need the support of bond investors who are willing to lend them money. The elevated interest in ESG considerations has also encouraged companies to be more open to proactively discussing ESG related topics.

We think fund managers should be assessing ESG factors as part of their investment process whether investing in shares or bonds, it’s simply good risk management.

Exclusions

One of the most common methods fund managers use is negative screening or excluding some bonds from investment. This means identifying companies, industries or countries that score poorly on ESG factors relative to their peers and excluding them from selection. These minimum standards allow investors to feel comfortable they aren’t funding industries that aren’t aligned with their morals.

By nature, screening leaves fund managers with a smaller selection of corporate and sovereign bonds to choose from. This could impact performance when excluded areas outperform the market, while also boosting performance when those same areas are underperforming.

Bonds issued by companies or countries that damage the environment, like those involved in the mining and oil & gas industries, are often excluded. So are weapons manufacturers and tobacco companies.

Supporting the transition

Some bond fund managers will invest in bonds like those issued by oil & gas producers if they’re confident the businesses have robust transition plans in place. Helping to fund traditionally ‘brown’ industries transition to become ‘green’ is a really important part of the global net zero transition.

Investors willing to fund the transition could benefit from a more diversified portfolio. However, these ‘browner’ companies face criticism that the nature of their business means they’ll never be environmentally sustainable. Investors can also face an increased risk of stranded assets – that’s where a previously valuable asset becomes obsolete or unneeded before it reaches the end of its useful life. This is why a clear decarbonisation plan is key.

Corporate bonds issued by the Danish power company Ørsted is a great example of successfully supporting the transition. Once one of the most coal-intensive companies in Europe, Ørsted committed to transform to be environmentally and financially sustainable, completing the divestment of its oil & gas production in 2017. It’s now one of the leading producers of offshore wind. 

Controversies

The current hot topic is weapons and whether they should be screened out by fund managers. There’s debate about whether defence companies can make a positive contribution to social sustainability by supporting the national defence of peaceful countries, like Ukraine. This is provided the weapons don’t end up in the hands of dictators or aggressors.

Fund managers need to appreciate the increased risk that these weapons could result in the indiscriminate killing of civilians.

At the country level credit rating houses have recently downgraded Russia’s sovereign debt rating, some to the lowest possible rating. War crimes and restrictions on Russian people’s freedom of speech fail to meet ESG minimum standards, and the sanctions imposed on the country have significantly increased the risk of default. This ‘junk’ status makes Russia’s sovereign bonds “uninvestable”.

While some sectors or sovereigns are entirely screened out of some bond funds, many fund managers use thresholds to avoid unintended exclusions. This is when the proportion of revenue generated from the ‘sin’ activity needs to exceed a certain value, often 5 or 10%, before the bond is excluded.

For example, a corporate bond issued by a company that manufactures and distributes alcohol has a different business model to a supermarket where a small proportion of their revenue is from alcohol.

Leave it to the experts

Liontrust Sustainable Future Corporate Bond fund uses exclusions in its investment approach. The managers won’t invest in any company that makes more than 5% of its revenues from a number of things. This includes alcohol, animal testing services, coal, oil & gas, gambling, intensive meat and fish farming, nuclear, ozone depleting substances, pornography, tobacco or weapons systems.

Sustainability and ESG analysis is fully integrated into the team’s investment process. They look to find bonds issued by high-quality companies whose core products or services make a positive contribution to society or the environment. This sustainability analysis is completed for every bond issuer in the fund.

The managers have the flexibility to invest in derivatives and emerging markets which if used adds risk.

The fund was recently added to our Wealth Shortlist.

Read our recent fund update

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

More about Liontrust Sustainable Future Corporate Bond, including charges

Liontrust Sustainable Future Corporate Bond Key Investor Information

We’ll be following this article with another that dives into two other ways bond investors can integrate ESG considerations into their investment processes. To make sure you don’t miss out on this and our other fund insights, sign up to our new weekly Fund Insight email.

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    Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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