How does socially responsible investing work with bonds?

Socially responsible investing – prioritising social and environmental good as well as financial return – is rising in prominence. Yet less tends to be said about how this relates to bonds – the debt of companies, governments and other institutions – as opposed to shares.

Lending to a business via a bond is generally less risky than being a part owner through shares, so bonds can play an important role in a portfolio. They can help temper the ups and downs of risker assets, as well as provide a decent, regular income for those who require it.

One obstacle that a socially responsible bond investor encounters is lack of voting rights. Shareholders get to vote on key decisions made at annual general meetings, but bond holders don’t have that direct route to influence policy. Indeed, many bond issuers are unlisted, meaning they don’t have publicly traded shares at all.

It is still possible for large bond holders to engage with companies, regulators and government bodies, though, and for investors looking to target a defined positive impact from their investments, bonds can have some significant advantages. There are only so many publicly listed companies that have tangible societal and environmental benefits and bonds can often offer a more direct route to positive outcomes.

Targeted outcomes

Bonds can be designated for a specific activity or project that involves a beneficial environmental or social outcome. This can be labelled a ‘green’ or ‘social’ bond, depending on what the expected benefit of the funding is, or as a ‘sustainable’ bond if there are elements of both. There is even a ‘blue bond’ category, which dedicates proceeds specifically to marine projects.

Importantly, bonds also come from a wide range of issuers, not just listed businesses. This is crucial for socially responsible investors as it opens up a more diverse set of institutions, such as supra-nationals including the World Bank and not-for-profit organisations like housing associations. Often these institutions will be better aligned with investors in wanting to create tangible positive benefits, rather than maximising profit, so their bonds can offer an attractive blend of financial outcomes and specific impact that isn’t available through stock markets.

The variety of borrowers in the market is illustrated by some of the diverse holdings in Rathbone Ethical Bond Fund, a constituent of our Direct Investment Service Preferred List. Among the portfolio there are a number of charity and green bonds funding areas such as social housing, sustainable transport, renewable power and environmental initiatives. These include Canal and River Trust, Thrive Renewables, Dolphin Living and South Bristol Sports Centre.

Another fund option in the area, Threadneedle Social Bond Fund, has brought investment to some of the UK's most deprived sectors and regions and supported the likes of Charities Aid Foundation in enhancing their work with donors and charities. It has also aided Cardiff University in funding an innovation campus and Manchester University in supporting the development of a new Cancer Research Centre. This year the fund also purchased a Covid-19 focused social bond from the African Development Bank.

Although still small in the context of global markets, this area is growing rapidly with green, social and sustainable bonds expected to reach $400bn this year. However, investors must tread carefully as sometimes there is scope for ‘greenwashing’ – making an investment appear more environmentally or socially focused than it really is. There are a number of agencies that certify bonds are genuinely being used for positive outcomes, and that proceeds won’t be used to fund any activities deemed negative. However, a qualitative judgement may still be required. For instance, while the proceeds of bond issuance may be designated in the right way, what about the cashflows being used to service the debt?

A virtuous circle

As more capital is dedicated to sustainable bonds, a virtuous circle is created. Existing green and social bonds tend to have lower yields than non-labelled equivalents, which in turn incentivises and encourages companies to participate in more of those types of projects, knowing they may be able to access capital at a lower rate than they would otherwise. This serves to increase supply to meet the growing demand.

This month, Chancellor Rishi Sunak announced that the UK will issue its first green gilts (UK government bonds) next year, following in the footsteps of France, Germany and others. It is hoped that by building out a range of green gilts of various durations, the government can cater to investors with socially responsible requirements and encourage further green issuance from British companies. Of course, there’s likely to be an added benefit: evidence suggests that green sovereign bonds also trade with slightly tighter yields than standard ones, reducing the cost of borrowing for the government.

The green gilt is aimed at helping fund the economic recovery from the Covid-19 pandemic, to the benefit of UK society as a whole, and to back green infrastructure projects. It is also good news for many socially responsible fund managers that have previously been barred from holding gilts as they are not seen as wholly ethical. This new issuance will provide a useful additional tool when managing their portfolios. Previously they have had to utilise quasi-sovereign or supranational alternatives.

If the experience in Europe is anything to go by, demand will be strong for green gilts. In spring this year, the Dutch government raised one of the largest ever green bonds, a €5.98bn issue, which will partly be used to finance natural infrastructure to protect the low-lying Netherlands from floods and sea-level rises. It was hugely popular with demand exceeding supply by three and a half times.

It seems we are only in the foothills of a long-term trend of increasing green bond issuance and over time there will likely be an expanding range of investments for socially responsible investors wishing to allocate to this asset class.

Find out more about Responsible Investing.

Please note: This article was released prior to SDR and thus the information may not be in line with the Anti-Greenwashing rule but contextually is appropriate for the time it was written.