Can Sustainable Bonds Save the World?

Bonds seem designed to make investors' eyes glaze over. Yields, maturities and credit ratings are not the stuff of cocktail-party conversation. But a fast-growing category of fixed-income investments promises to change that, transforming stodgy bonds into a vehicle for corporate governance, social and environmental change.

These “sustainable” bond funds include broadly diversified index funds that buy bonds from issuers with solid environmental, social and governance (ESG) practices; actively managed funds that engage with corporate and municipal issuers to fund ESG-related projects; and more specialized offerings, such as funds that buy environmentally focused “green” bonds.

The number of sustainable bond funds has grown quickly as investors recognize the potential credit implications of climate change, product safety and other ESG risks. There were 58 taxable sustainable bond funds at the end of 2018, up from 34 a year earlier, according to investment research firm Morningstar, and they cover the fixed-income waterfront from ultra-short-term to emerging markets bonds.

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These funds aren’t just feel-good investments. Tilting a fixed-income portfolio toward bonds that score well on ESG measures generally leads to higher returns, according to a 2018 report by Barclays.

Know the Risks

But these funds can also present challenges for investors Some invest in small issues that can be difficult to trade, so investors will want reassurance that the manager is adept at managing liquidity risks. What’s more, ESG scoring is complex, and methodologies vary from one research firm to the next.

Sizing up ESG risks can be particularly thorny for bond investors. Environmental risks that may be minimal for a one-year bond, for example, may be critical for a 30-year bond, says Henry Shilling, founder and research director at Sustainable Research and Analysis, in New York City.

These funds don’t have to be pricey or complex. Low-cost, broadly diversified bond funds that track indexes composed of ESG leaders include Fidelity Sustainability Bond Index fund and iShares ESG US Aggregate Bond exchange-traded fund, both launched last year.

Other funds take a more active approach and engage directly with issuers. In the TIAA-CREF Social Choice Bond fund, about two-thirds of assets are devoted to the bonds of ESG leaders, while roughly one-third is focused on impact investing—seeking measurable change alongside financial return. That approach allows the fund to work with some issuers who might not pass its standard ESG screens, says Stephen Liberatore, the fund’s manager. The fund wouldn’t buy the corporate debt of utility company Exelon, for example, because of its nuclear power operations, he says, but it has worked with Exelon’s renewable energy subsidiary to invest in bonds that fund wind farms.

Investors with an environmental focus might also consider green bond funds, which hold bonds that fund projects with environmental or climate benefits. The iShares Global Green Bond ETF, launched last year, holds U.S. and international investment-grade green bonds and hedges out currency fluctuations to give investors a smoother ride. Read a fund’s prospectus, annual reports and manager commentary to understand its sustainability strategy. Some funds fully integrate ESG criteria into every aspect of their investment process, while for others, ESG is just one among many factors considered. In many cases, “there’s very little disclosure around actual impact,” Shilling says. But some funds, including the iShares green bond ETF and TIAA-CREF Social Choice Bond, produce impact reports that translate their investments into energy saved, carbon emissions avoided and other measurable results.