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How to build a sustainable bond portfolio

Four asset classes have been identified for investors seeking to align their portfolios with their social mission.

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Asset managers are looking at the existing debt market with fresh eyes, tapping into potentially overlooked asset classes such as affordable housing and development bank debt to find investable opportunities for sustainability-hungry clients.

WALL Street's do-good investment boom is finally taking notice of the credit markets. Sustainable investment assets grew 37 per cent last year, according to Bloomberg data, but the majority of those funds focus on stocks.

That's leading to awkward conversations on Wall Street, as wealthy investors and foundations increasingly seek to align their entire portfolios with their social mission, but are finding few opportunities to do so in fixed income.

Rui de Figueiredo, co-head and chief investment officer of the Solutions and Multi-Asset Group at Morgan Stanley Investment Management, said: "Most of the people who are interested in incorporating ESG (environmental, social and governance) are interested in doing so throughout their portfolio."

Yet, with a dearth of available fixed-income products categorised as environmental, social and governance, those investors haven't looked at it much. "But that creates more demand on the part of asset managers to create those opportunities."

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Of almost 1,900 ESG funds tracked by Bloomberg, 15 per cent invest in fixed income, vs 62 per cent in equity. On an asset basis, that figure is even smaller, with fixed income representing about 3 per cent of the US$491 billion invested in such funds.

Bonds, though, have the potential to be a popular ESG asset class for impact investors, those who look to generate environmental and social outcomes along with financial return. Fixed income typically attracts investors with longer time horizons, and who might be more philosophically aligned with environmental and social issues, says Mike Amey, head of sterling portfolio management and ESG strategies at Pimco Investment Management Co.

A World Bank report released in April details some initial evidence that ESG factors can help bond investors avoid default risk.

To fill the gap, asset managers are looking at the existing debt market with fresh eyes, tapping into potentially overlooked asset classes such as affordable housing and development bank debt to find investable opportunities for sustainability-hungry clients. They're also trying to build, for example, benchmarks, that will support greater liquidity and investment levels in these products.

Here's what's going into sustainable bond portfolios:

DEVELOPMENT BANK DEBT

High-grade debt issued by the World Bank and other development banks offers some of the best-performing do-good credit on the market, according to UBS Group AG, which found that the debt delivered strong returns for its socially conscious private-bank clients.

Development bank debt turned out to have "a very attractive expected risk-return over a cycle for AAA-rated debt," said Simon Smiles, chief investment officer for ultra-high-net-worth clients at UBS's wealth-management division. That performance encouraged Solactive AG, a German provider of indexes, and UBS to create in April a development bank bond index family to make the debt more accessible for investors.

GREEN BONDS

The market for environmentally friendly bonds is expected to hit a record US$170 billion in new issuance this year, but these bonds are in relatively short supply, according to Bloomberg NEF. They represent less than 0.5 per cent of the global fixed-income market. Most deals are oversubscribed; their environmental credentials appeal to long-term investors.

If you can get your hands on a green bond, you'll find the sector has been dominated this year by sovereign, local government and financial issuers, which use the proceeds to fund smaller projects on, for example, renewable energy and green buildings.

Social and sustainability bonds, which home in on themes such as responsible farming or housing finance, are also a budding area, with about 25 deals this year. But there are only about 110 bonds on the market, with a total issuance of about US$47 billion, said Bloomberg.

MUNI BONDS

The municipal bond market is an "abundant source of potential investments" in ESG, said James Iselin, head of the municipal fixed-income team at Neuberger Berman Group LLC.

The asset manager recently retooled the focus of an existing US$56 million muni fund to centre on impact investing. Debt issued by local communities can have a positive effect, funding energy and water-treatment projects, schools, and public transportation; it can also help investors lower their tax liabilities. Eaton Vance's Calvert Research and Management, AllianceBernstein and Columbia Threadneedle Investments have launched such funds.

ESG-RATED BOND PORTFOLIOS

Fund managers such as Pimco, Fidelity Investments, and Brown Advisory Inc are building their sustainable fixed-income funds by selecting bonds issued by companies that perform well on ESG ratings maintained by third parties such as Sustainalytics and MSCI Inc. REAL ESTATE

When the Ford Foundation last year committed US$1 billion from its endowment to "impact investing", it said one of its top initial investment targets would be affordable housing. Community Capital Management Inc, an impact-investing company that oversees about US$2.3 billion, slices up portfolios so investors can use their fixed-income strategies to support housing in a number of categories such as disaster recovery, minority neighbourhoods, arts and culture programmes and sustainable agriculture.

Environmentally-friendly buildings are also presenting opportunities. Federal National Mortgage Association, for example, was the largest issuer of green bonds in the world last year, selling more than US$27.6 billion in green mortgage-backed securities last year, up from US$3.6 billion the year before. The US government-backed firm, which guarantees housing-related debt, built the securities by pooling financing for green-certified apartment buildings. The water- and energy-efficiency modifications made to the properties in those portfolios will likely reduce utility bills, said Fannie Mae.

CDFI

Community development financial institutions (CDFIs), which provide affordable lending to low-income and underserved communities, are gaining traction with impact investors. Banks have been the primary investor in the area for years, thanks to the 1977 Community Reinvestment Act, which encouraged commercial banks to meet the lending needs of their local communities.

This has given CDFIs a long performance history. Some are even large enough to have credit ratings, which makes them appealing to retail investors, according to Louise Herrle, a managing director at Incapital LLC, an underwriter and distributor of fixed-income securities to broker-dealers and financial advisers. "They've been in the market for quite a long time, so people have a comfort level with them," she said. CDFIs are also courting impact investors, allowing them to raise more capital so they can expand, he says. WP