A combination of shifting attitudes, greater transparency, and a wider variety of available investment products means that investors can now choose fixed income strategies that make ‘good’ use of their capital.
While the amount of UK retail investor money invested in ethical funds continues to hover around the 1 per cent mark, awareness of environmental, social & governance (ESG) issues is making investors take a second look at the sector.
Source: Investment Association
While there are many well-known and longstanding equity strategies in the sector, there are a growing number of ethical bond funds for investors to choose from.
For Victoria Hasler, head of research at Square Mile Investment Consulting and Research, the benefits of investing in ethical bonds, other than the usual benefits of investing in bonds generally (income, diversification, etc), are largely centred around the non-monetary impacts which one can make through these investments.
“These may include a positive impact on society and/or the environment, avoiding controversies, and setting a positive example,” Hasler said.
She cautioned, however, that investors should carefully consider what they want to achieve from their investments (in both monetary and ethical/ESG terms) and make sure that a fund not just meets their financial goals, but is also in line with their ethical investing goals.
Apart from the usual risks associated with investments in bonds, she said, ethical bonds present “two obvious extra risks”.
“The first is that you may, depending on the investment, have to give up some return, or take on some additional risk, to invest in this way, and as a result may need a longer time horizon for investing,” she explained.
“The second is that the investment which you make, for some reason, does not behave in a way which you expect in terms of its ethics, or does not meet your sustainability goals.
“This may be because of a change in management or a fraud for example, or just because the values of the fund and those of the investor differ.”
There are a lot of different shades of green, she pointed out, and “ethical” can mean different things to different people.
“Investors should make sure that, as well as the usual financial due diligence which they undertake on a fund, they carry out sufficient research into an investment’s ESG credentials to ensure that they are valid and match the investor’s own expectations of what they want from an ethical investment,” Hasler said.
Rob Morgan (pictured), pensions and investment analyst at Charles Stanley, said there are a number of cases to be made for ethical investing.
“The main one is that companies that do right by their customers and workers, and are responsible stewards of the environment, are more sustainable than ones that have dubious practices,” he said.
Morgan cited the Volkswagen emissions scandal as a perfect illustration.
Performance of Volkswagen over 5yrs
Source: Yahoo! Finance
“The risk of owning ‘non-sustainable’ businesses is higher and therefore their cost of capital should also be higher,” he said. “This leads to weaker returns, and of course there is the chance they could, over time, have some kind of ‘blow up’ or ultimately prove to be unsustainable.”
He said green or ethical bonds can represent highly targeted investments, with companies or institutions raising money for specific projects – which often have a measurable social or environmental impact.
“This could vary from affordable housing to green energy infrastructure to social care,” he added.
As such, Morgan finds the popularity of ethical bonds quite rational, adding: “Unlike most individual equities, where buying shares means partaking in all the strands of a company, they can represent a ‘pure play’ on a certain beneficial initiative.”
In the current situation, he expressed “a concern that demand exceeds supply, but the pipeline of issuance is set to broaden.”
He said the overriding factor is prospects for the bond market in general, and specifically the outlook for interest rates. “The consensus is for rates to stay low, but if this changes then it’s bad for most bonds.”
The analyst also sees a potential pitfall in ethical bonds’ growing attractiveness to investors.
“One concern is it could become a popular and crowded trade, and this could lead to poor risk-adjusted returns,” he said. “There may also be illiquid areas, although you could say this about other areas of specialist fixed interest.”
However, there are still some prejudices that managers in the space need to overcome, according to Rathbones’ Noelle Cazalis.
Cazalis, an assistant manager of Rathbone Ethical Bond fund alongside Bryn Jones since 2016, said that misconceptions about ethical funds and underperformance were outdated.
“A persistent myth is that ethical funds don’t perform as well as non-ethical funds,” she said. “The reality is that we have outperformed the majority of other corporate bond funds for three years, five years, and seven years.”
One of the major objectives of the fund, Cazalis said, is to pay a high yield, and that the income from the fund is among the highest in the sector, “illustrating that income and ethics can be combined without sacrifice”.
To accomplish this, the portfolio manager said, the fund invests in investment grade bonds of reliable companies with solid business plans and stable management teams.
She said investors are attracted to bonds in particular because they are safer and less volatile than equities.
“With a fixed coupon rate, a bond yield is more predictable than a dividend yield,” she noted.
The £1.2bn Rathbone Ethical Bond fund is a corporate bond fund launched in 2002 and invests mainly in sterling-denominated bonds.
“We apply strict rules when assessing whether a company is ethical. The fund runs every investment through a negative and positive screening process,” Cazalis added.
“If a company has one negative then it is excluded from the fund. We feel this is the best way to get what we think is an ethical return.”
Its holdings include Thrive Renewables, a clean energy company established in 1994 in response to the Chernobyl disaster. Another one is Greensleeves Home Trust, a high-quality care home charity operating 18 residential care homes and two nursing homes in the Midlands, south and east of England.
Since lead manager Jones took over the five FE Crown-rated Rathbone Ethical Bond fund in 2004, it has made a total return of 107.43 per cent against a 118.92 per cent gain for the IBOXX UK Sterling Non-Gilts All Maturities index and an 86.62 per cent return for the average IA Sterling Corporate Bond peer.
Performance of fund vs sector & index under Jones
Source: FE Analytics
The Rathbone Ethical Bond fund has a yield of 3.8 per cent and an ongoing charges figure (OCF) of 0.67 per cent.