3 Ways to Build an ESG Bond Portfolio

With yields on the rise, bonds are looking better and better — especially as stocks stumble in their wake. But bond prices are at the highest they’ve been in nearly a decade, giving investors pause.

Where to turn for safety and value? Fixed income experts point to ESG bonds.

“These issues can potentially benefit investors in all kinds of interest rate climates because of the byproducts of greater investor demand, enhanced liquidity, tighter spreads, reduced risk and potentially higher returns,” says Patrick Drum, portfolio manager of the Saturna Sustainable Bond Fund at Saturna Capital. “Our research into the impact of ESG on the performance of U.S. investment-grade corporate bonds in the past seven years has shown that portfolios that maximize ESG scores while controlling for other risk factors have outperformed the index, and that ESG-minimized portfolios underperformed.”

Often relegated to the equity markets, ESG investing can be of even greater benefit to fixed income investors, he says. As an ESG investor, you’re really looking at building resiliency into your portfolio, Drum says. And resiliency is paramount in fixed income. The challenge then is how to build an ESG fixed income portfolio to withstand any market storm.

How to find ESG bonds. For the individual investor, there are essentially three ways to build an ESG fixed income portfolio, says Eddie Bernhardt, senior portfolio manager at OppenheimerFunds SNW Asset Management in Seattle: buckle up and do a lot of homework, rely on analyst ratings, or hire an asset manager to build an ESG portfolio for you.

The CFA Institute and Principles for Responsible Investing reviewed the ESG techniques used by leading practitioners across the globe to create an ESG integration framework for investors, published in their ESG best-practices report,”Guidance and Case Studies for ESG Integration: Equities and Fixed Income.”

Shaped like a bull’s-eye with ESG integration at its center, the framework involves no fewer than 27 elements covering research, security evaluation, scenario analysis, risk management, portfolio construction and asset allocation. Some of the strategies include looking at workplace injury rates, the composition of the board of directors and the ESG risks faced by a company’s suppliers and business partners.

While “there’s no one best way to do ESG integration,” the hope is that the framework will serve as a tool for ESG investors, says Matt Orsagh, director of capital markets policy at the CFA Institute in Charlottesville, Virginia. He advises starting with the bull’s-eye (on page 5 of the report), then reading through the section on fixed income to determine which of the strategies you can incorporate into your investment selection process.

[See: 9 Ways to Invest in America With Bond Funds.]

Align your maturity with ESG risks. “The feedback you get from ESG data could influence the maturity of the bonds you invest in,” Orsagh says.

Unlike shareholders, bondholders’ relationships with companies have an expiration date. When the bond matures and your principal is repaid, what happens to the company no longer impacts bondholders.

Since ESG risks tend to be long-term in nature, a company’s short-term bonds may be investible even when its longer-term ones are not. On the flip side, if a company with a poor ESG history changes its ways, you may opt for longer-term bonds over shorter ones, Orsagh says.

Take a sector-specific approach. When researching ESG risks, materiality is key. For example, while toxic emissions may be an important risk factor for mining companies, it’s less relevant to those in financial services. Evaluate ESG risks through the lens of a company’s industry.

With one exception: governance. Risks associated with corporate governance are relevant to all issuers.

“The governance [factor] is our evaluation of [an issuer’s] ability and willingness to pay back their debt,” says Eric Glass, portfolio manager of fixed income impact strategies at AllianceBernstein in New York. It speaks to if an issuer is a good steward of capital and transparent in their finances.

Governance risks can largely be determined by a company’s credit rating, he says.

[See: 8 Ways to Build a Low-Cost Portfolio for Social Change.]

Beware of ESG ratings and green bonds. If doing your own homework sounds like too much trouble, there is an alternative: Place your trust in ESG ratings or green bonds.

Most of the major credit rating agencies now incorporate ESG risk into their rating criteria to varying degrees. But if you’re going to rely on analyst ratings, you need to understand the methodology behind the rating and any blind spots that may exist, says Glen Yelton, ESG and impact research analyst at OppenheimerFunds SNW Asset Management in Seattle.

For example, the data provider behind Morningstar’s sustainability fund ratings doesn’t cover municipal bond data, he says.

Green bonds aren’t ESG bonds. Green bond labels are similarly problematic. “ESG is a broad umbrella term,” Yelton says. “Green bonds are a narrow subset focused on financing environmentally-positive projects.”

The International Capital Markets Association (ICMA) maintains a list of issuers that meet their green, social and sustainable bond principles and guidelines, which can be downloaded from their Resource Center. Similarly, the Climate Bond Initiative has an online list of certified climate bonds meeting their Climate Bonds Standard.

But a bond being labeled green says nothing about the environmental, social and governance risks faced by the issuer.

“These are self-labeled issuances, meaning the issuer determines whether the [bonds] qualify,” Yelton says. Look for second- or third-party verifications of the “greenness” of the bonds. Both the ICMA and Climate Bond Initiative’s lists include links to outside verifications.

The difference between ESG and green or socially responsible investing comes down to a question of value versus values, Orsagh says. Choosing not to invest in “sin stocks” or to only buy green bonds is based on personal values. ESG investing, however, is intended as a value approach to increasing risk-adjusted returns.

The case for active management. “These markets can be idiosyncratic,” Glass says. “They can be nebulous. And that’s the benefit to hiring active managers.”

Large investment firms will have more resources and clout with companies than an individual investor. For instance, part of the research element outlined by the CFA Institute is engagement with the company. As an individual investor, you probably won’t be able to speak directly with companies on their ESG practices. But a large fund manager may have better luck.

Impact investors can target funds whose providers have strong engagement teams that work with companies on improving their ESG ratings. Many companies, especially those that are indexed like Vanguard, BlackRock and Fidelity, are expanding their engagement teams as they increasingly realize their importance to investors, Orsagh says.

If you’re investing in a fund that’s going to vote on your behalf, you may want to look at the company’s voting record on these issues, he adds.

But relying on ESG bond funds has its own set of risks. While there are a number of products that may satisfy the loosely-ESG investor who doesn’t mind a slightly-modified version of an index, as you move along the spectrum and become more restrictive in your goals around ESG, you’ll need more information, Bernhardt says.

[See: 7 Bond Funds to Buy as Rates Rise.]

“Whoever you choose as your manager, you need to get inside their system to understand [how stringent it is] and how it aligns with you,” he says.

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3 Ways to Build an ESG Bond Portfolio originally appeared on usnews.com

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