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Equities have formed the basis of most new sustainability-focused investment products in recent years, but fixed income is finally gaining a foothold.
Last year, the amount of money invested in Canadian mutual funds or exchange-traded funds (ETFs) with an environmental, social or governance (ESG) focus almost doubled to $34.5-billion from $17.4-billion in 2020, according to a recent Morningstar Inc. report.
While 77 per cent of net inflows went to equity funds versus just 18 per cent in fixed-income funds, Ian Tam, director of investment research at Morningstar Canada, says the announcement of Canada’s first green bond issuance in March should bring more attention to the space.
“Once the federal government issues a green bond, that’s kind of a signal to the market and lends support to the idea,” he says.
Part of the reason for the limited inflows into sustainability-focused debt products is simply an issue of supply, Mr. Tam says, as “the universe of domestic sustainable bonds is small,” but growing.
Naveed Mohammed, vice president and head of managed asset strategy and analytics at BMO Nesbitt Burns Inc., says that as education and product availability gets better, there will be more fixed income products under the sustainability umbrella.
“We are starting to see that already,” he says.
A recent example comes from Export Development Canada (EDC), which has been issuing green bonds since 2014. Last month, though, the federal agency laid out plans to start issuing two other ESG products – transition bonds for projects that support the low-carbon economic transition and social bonds that fund women and minority-led businesses.
Demand for sustainable debt products has been enormous. The federal government’s first green bond issuance ended up attracting more than $11-billion in orders despite planning to raise just $5-billion. Globally, Moody’s expects a record US$1.35-trillion worth of sustainable bonds to be issued in 2022, potentially accounting for 15 per cent of all bond issuances.
Transparency and knowledge issues
Yet, in Canada, Mr. Mohammed says supply has remained low in part because of how ESG products are presented to the public.
“All the marketing that is done when people think about ESG or sustainability is from an equity context,” he says. “You think of it from an owner and influencer [perspective] that when you own a [mutual] fund or ETF, you own shares for proxy voting or having influence.”
Recent guidance from the Canadian Securities Administrators on a proposal for issuers to start disclosing climate-related risks is also likely to make it easier for advisors to recommend fixed income products to clients looking for more sustainable investing options, according to Morningstar’s Mr. Tam.
“Right now, the transparency just isn’t quite there,” he says. “When you have more information, that gives investors more tools to find the right bond from the right issuer.”
Mr. Tam adds that should be a catalyst for advisors as they don’t have that information now.
Another part of the education process that still needs to occur is understanding that sustainable investments don’t necessarily have an extremely narrow focus, according to Pat Fletcher, chief executive officer of the Responsible Investment Association (RIA).
“It refers to a broad series of approaches for incorporating ESG factors into investment decisions and stewardship,” she says.
As the new know-your-client guidance becomes a best practice, Ms. Fletcher thinks we will start to see more advisors incorporating ESG factors and personal values into portfolio choices and decisions.
How much ESG fixed income should investors hold?
In terms of how large a proportion of fixed income holdings could be moved into sustainability-focused products, Nesbitt Burns’ Mr. Mohammed says the funds have “similar credit and risk exposure” to more traditional debt products and can be considered as a replacement.
“The return tradeoff is not substantial,” he says, noting green bonds typically trade at a 4 to 5 basis point premium. “That is not substantial enough to make much of a difference to client portfolios.”
However, it is about understanding that these tradeoffs can be made now without increasing the risk of reducing the client’s return, he adds.
Mr. Tam takes it a step further, noting that the so-called green premium is not always there. Multiple studies have found that as demand for sustainable investment options grows, the premium investors are expected to pay for those products falls.
The result is sustainable fixed income investments no longer need to be the domain of ultra-high-net-worth clients who can sacrifice returns to have an impact or a more socially conscious return, Mr. Mohammed says.
“Now, there are both growth and value products,” he says. “So, you can really replace core portfolios with sustainable products.”
For advisors, the RIA’s Ms. Fletcher says the key takeaway of this trend is that there will be an expectation from clients to be able to have these conversations with their advisors.
“A greater onus is [now] placed on advisors to increase their literacy around [sustainable investment options],” she says.
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