At AIM we are dedicated to managing impact fixed income portfolios. Our vision is to mobilise mainstream capital to proactively address the challenges the world faces, such as climate change, global health and social inclusion.
As an investor focused on driving innovation and change in a responsible manner, we consider any potential investment through two lenses: ESG integration and Impact. Together, these two approaches enable us to leverage the inherent potential of capital markets to channel investment into sustainable solutions.
The past decade has seen increasing awareness of ESG integration among investors as well as issuers. Both corporates and governments are cognisant of the greater focus on governance, environmental and social risks. ESG integration can be applied across all asset classes, including debt, equity and unlisted and private assets.
But is ESG investing enough? Should investors also consider impact when making investment decisions?
ESG investing explicitly incorporates environmental, social and governance factors into the investment decision-making process either as a return driver or as a risk mitigator.
Many managers today claim they incorporate ESG into their research and analysis. It is important to see what an asset manager has done to incorporate ESG factors into their process, and how they apply the analysis.
We believe that integrating ESG into the decision-making process should lead to better risk-adjusted returns over the long-term, and there have been studies to support this.[1] However, we do not think this goes far enough.
We believe the future is impact investing.
What does this mean for fixed income?
While there is a strong relationship between the two methodologies, there are also some key differences between ESG and impact when it comes to fixed income.
ESG fixed income is the addition of ESG considerations alongside traditional financial analysis when investing in bond markets. ESG integration encompasses the systematic and explicit inclusion of material environmental, social and governance factors into investment decision-making. The focus is primarily on the profile of the issuer.
Impact fixed income investing, on the other hand, builds on ESG by focusing on bonds which deliver measurable environmental and social outcomes, as well as delivering mainstream financial returns. Impact investing is an investment discipline built on applying a rigorous, evidence-based assessment to understand the outcomes delivered by the use of bond proceeds, monitoring those outcomes and then reporting on impact. Often, but not always, labelled green, social and sustainability bonds can be considered for inclusion in an impact bond universe. In some cases, unlabelled ‘pure play’ or ‘aligned’[2] bond issuers may also be included, provided the issuer’s business model itself is wholly focused on delivering positive outcomes.
The crucial difference between ESG integration and impact is that impact fixed income delivers positive outcomes.
ESG analysis looks solely at the company or country that is issuing though an environmental, social and governance lens. There is no guarantee of positive environmental or social impact. It is about understanding the risks and opportunities around the issuer, and therefore the intention is for the analysis to act as a return driver or risk mitigant.
Within impact fixed income, positive outcomes are of the utmost importance, and ESG factors are incorporated alongside measurement and reporting of impact. At AIM, we include both the issuer and the issue in our analysis. Reporting is primarily at the project level and therefore provides the investor with greater insight into the impact their investment is having. Impact investing identifies and accelerates the capital allocated to solve the world’s climate and social challenges.
Verification is critical
In both ESG integration and impact investing verification is critical. Investors must have their own lens through which they analyse their holdings to ensure they meet the standards expected by their clients.
Given impact fixed income is largely a self-labelled market, verification by asset managers is especially important. Theoretically any issuer could issue a bond and label it green, and different shades of green can be found in the market. Verification of both issuer and the bond itself is therefore key to ensure that the investment is truly achieving a positive impact.
Our proprietary SPECTRUM process, which we apply to all issuers and bonds included in our investment universe, has verification at its core.
Impact investing is the way of the future
There are two important questions to answer when considering impact investing: can you deliver mainstream returns and can you have a positive impact? It is these factors which underscore whether impact investing is the way of the future. We believe you can achieve both.
As a reminder, from a financial perspective an impact bond is just a bond. The impact bonds which we invest in at AIM are generally the senior debt of an issuer, pay a fixed or floating coupon and mature at par. The bonds usually trade at a similar yield to equivalent bonds from the same issuer. It is what the proceeds are used for that make them impact bonds.
To be a green bond, the proceeds are generally used to fund projects or make loans which have a positive environmental impact. The proceeds could focus on adaptation, for example helping communities to adapt to more volatile weather, or mitigation, helping the world to reduce carbon emissions. Flood defences and solar wind farms are examples of such investments.
For social bonds, proceeds are used for the funding of projects which have a social outcome. An example is the “Fight-COVID-19” bond issued by the African Development Bank this year, which, at the time of writing, is held in our portfolios. This is the senior debt of the African Development Bank, carrying a AAA rating. The proceeds of this US$3bn issue will be used to directly fund the construction of medical facilities to fight COVID-19 and to offset the economic consequences of the virus in African countries. For more on our thoughts around investing in COVID-19 bonds, please see our website here.
Sustainability bonds are a newer form of impact bonds. These allow for the funding of both green and social projects within the same framework. Sustainability bonds are becoming increasingly popular in the market. New South Wales Treasury issued its first sustainability bond in 2019, with proceeds financing projects in areas such as affordable housing, global health and water management.
The impact bond market has continued to grow rapidly since its inception in 2008. There is now over US$1 trillion impact bond issuance outstanding. With its growth, the market has become more liquid and more investable. For example, the French green Obligations assimilables du Trésor (OAT), issued by the French Treasury, is now a €27bn issue. The market has also become more diverse. The first issuers were the World Bank and European Investment Bank (EIB) in 2008 and the market was initially dominated by these organisations alongside other supranationals. With time, we have seen more corporate and sovereign issuers. The market is now around 40% corporate issuers. Having filled out in terms of rating buckets, yield curves and currencies, the market is increasingly reflective of the opportunity set of the global bond market.
We believe that the increasing climate-related regulation, broadening of fiduciary responsibilities to encompass climate risks, consumer awareness, advances in technology and increased government spending targeting green stimulus will continue to drive issuance and investments in solutions that combat climate change.
It is therefore possible to manage a portfolio of impact bonds against broad market indices and generate mainstream financial returns with environmental and/or social impact.
The importance of reporting on impact
Given the impact bond market is growing in depth and breadth, it is important to understand if the impact of these bonds is measurable. Impact reporting is critical, both to impact bond managers and to asset owners who are investing in this space. Each impact bond usually funds multiple projects. Reporting therefore includes extensive data collection and measurement at both a project and issuer level in order to gain sufficient transparency to report the true impact across all impact bonds in our portfolio.
Our impact reports include the headline impact of our clients’ portfolio, key impact metrics, alignment to the UN Sustainable Development Goals (SDGs) and case studies on the projects we have invested in. The case studies and metrics allow investors to truly understand the impact and difference the investments are making. The coverage ratio is a critical measure in any impact report. This demonstrates how much of the portfolio is actually measured and used to represent the overall impact of the portfolio. Our portfolios have coverage ratios of over 90%.
A key metric within impact reporting is the amount of GHG emissions avoided through the investments made. In 2016 we partnered in the development of the Carbon Yield® methodology, with funding from the Rockefeller Foundation, which enables reporting on the carbon savings associated with investments. This is a publicly available tool which we hope will become an industry standard measure of the carbon abatement associated with projects. We have also begun to integrate TCFD[3] recommendations into our impact reports. In 2019, through our partnership with South Pole, we conducted a physical risk assessment of our portfolios against four climate scenarios. We also reported on key carbon metrics such as the Weighted Average Carbon Intensity (WACI).
From a financial perspective, we manage largely developed market portfolios with an AA- average credit rating. It is worth noting, however, the impact is much broader, as the projects funded by developed market issuers span the globe. Despite our portfolios taking predominately developed market risk, our clients are able to have a much larger impact, in emerging and even frontier market economies.
To explore our full impact report please refer to the following link here.
Is the future of your portfolio going to be around impact?
We believe ESG analysis is critical when investing in the fixed income market. However, ESG analysis does not go far enough. ESG investing does not incorporate critical features such as verification and reporting on outcomes. The future of investing in fixed income, and in other asset classes, is about impact. It is impact investing which will accelerate capital to solve the world’s climate and social challenges and show investors the outcomes of their investments. We believe that you can produce mainstream returns with the addition of a positive social and/or environmental impact.
Stephen Fitzgerald, Co-Managing Partner, recently shared his views on this subject at the Portfolio Construction Forum. You can watch the video on their website, here.
Further reading around this topic is also available on our website here.
[1] Ferrarese, C. & Hanmer, J. (2018) ‘The impact of ESG investing in corporate Bonds’. Available at: https://page.ws.fidelityinternational.com/rs/829-LMV-001/images/ESG%20White%20Paper%20FINAL.pdf how
[2] An ‘aligned’ issuer, from an AIM perspective, is an issuer with high levels of responsibility and disclosure that delivers products or services where at least 50% of revenues are generated from sectors aligned with the AIM taxonomy of environmental and social sectors.
[3] The Task Force on Climate–related Financial Disclosures (TCFD) was established by the Financial Stability Board (FSB) with the aim of developing voluntary, consistent climate-related financial disclosures that would assist the financial industry in assessing material risks.