A Look Inside Green Bonds: Combining Sustainability with Core Fixed Income

S&P Dow Jones Indices
Written By: Dennis Badlyans, Aye Soe and Hong Xie
S&P Dow Jones Indices
Written By: Dennis Badlyans, Aye Soe and Hong Xie

In recent years, an increasing number of market participants have shown interest in sustainability-driven investing and have started to incorporate elements of environmental, governance, and social (ESG) factors in their investment processes. Various rationales have been given for the inclusion of these factors.

The first rationale is that from a risk/return perspective, companies that consider impact investing and ESG practices associated with their business activities are likely to be ahead of their peers. From an environmental standpoint, actively managing a portfolio’s footprint may help decrease exposure to companies that may face legal and reputational risks and provide a hedge against future regulatory changes. For example, as the world transitions to a low-carbon economy, organizations that have been proactive will be better positioned to adapt to new regulations, innovation, or a shift in consumer appetite.

The second rationale for investing in these types of companies comes from social or personal values and goals. These investors aim to create portfolios that balance financial returns within the scope of mission objectives.

No matter the rationale, there is a wide range of options for fixed income market participants to navigate. A common approach to navigating among these options has been to rely on evaluation metrics, or ratings that measure the ESG impact of companies’ operations, and overlaying the score onto assets. The main challenge of this approach is that currently there is no clear standard of measurement in the market.

Researchers at MIT who worked on the Aggregate Confusion Project found that when comparing “two of the top five ESG rating agencies and compute the rank correlation across firms in a particular year, we are likely to obtain a correlation of the order of 10 to 15 percent. At least the correlation is positive! It is very likely (about 5 to 10 percent of the firms) that the firm that is in the top 5 percent for one rating agency belongs to the bottom 20 percent for the other.”

Within fixed income, green bonds can solve this problem and offer an opportunity for market participants to add an element of impact investing into their core exposure in a simple way. Furthermore, compared to other environmental indicators available, green bonds are arguably the most forward-looking measure.

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