Partner Insight: Why impact bonds make financial sense

Using capital to intentionally support social and environmental goals, while measuring and reporting the impact it achieves, is integral to the ethos of impact investing. Traditionally, investors have primarily focused on that altruistic aspect, but, as a team, we believe impact investing also makes powerful financial sense. In our view, doing good with your capital can help to meet, and potentially exceed, your financial goals. Here we outline some of the factors that we think underpin the long-term return potential of fixed income impact portfolios.

The power of capital flows

Historically limited to private investments, impact investing is establishing a stronghold in public markets, and creating potentially attractive return opportunities for investors. While equities marked a natural starting point for public market investors on their impact journey, investors are recognising the potential of their fixed income allocation to generate meaningful impact, along with competitive financial returns. We believe that the scale and depth of fixed income markets makes them particularly appealing to regulators, policymakers and investors who are looking to channel capital towards projects that aim to solve long-term sustainability challenges. Public debt is now the fastest-expanding asset class within the impact universe, increasing at an annualised rate of 101% over the past five years.¹

In our view, impact investing is part of the sustainability megatrend that is reshaping public market investing and shifting capital. We think that this accelerating investor demand for impact fixed income will bolster high-quality impact issuer and security performance in the near and medium term, to the benefit of investors who can identify these issuers early on through their research.

Structural drivers of performance

We see several structural drivers supporting the investment performance of impact issuers over time. Below we outline three key factors:

• Demand — As awareness of environmental and social issues increases, consumers are favouring products and services that align with their values.² Companies that address these challenges with innovative solutions are likely to attract higher demand for their offerings, achieve a lower cost of funding and potentially higher profitability.
• Competitive advantage — Issuers that innovate to address environmental and social challenges, we think, may have an opportunity to gain a competitive edge in their industries. Developing scalable and cost-effective solutions can position these companies as leaders and open new revenue streams and markets. Such issuers tend to stay ahead of the curve, attracting customers seeking modern, sustainable and effective products or services. Overall, these issuers' ahead-of-the-curve positioning may lead to larger market share, greater growth prospects, more robust balance sheets and better returns for investors.
• Long-term orientation — Impact investments inherently focus on addressing long-term, systemic challenges. Having such a long-term orientation encourages companies to adopt strategies that prioritise responsible and sustainable growth. When companies support a positive impact through their core goods and services, they are more likely to engage in business practices that foster environmental stewardship, social equity and transparent governance. These factors can lead to improved risk management, enhanced reputation and better relationships with stakeholders, all of which could, in our view, contribute to greater resilience and longer-term value creation.

In our experience, markets appear to increasingly acknowledge these potential long-term advantages of companies with ESG-aligned business practices. Data from Barclays Research³ suggests that issuers with high ESG ratings are accessing capital at a lower cost than their laggard counterparts. As the investor base widens, we expect impact issuers to benefit from a similar dynamic, again highlighting the favourable structural tailwinds driving the asset class.

The active advantage

In our opinion, the public fixed income market impact opportunity set now offers the scale and liquidity to apply active management in the pursuit of above-market returns and impact that is material, additional and measurable. Today's more cyclical and volatile environment further underscores the need for an active approach to help strengthen the longer-term resilience of fixed income impact portfolios.

In managing our fixed income impact portfolio, for instance, we implement the same dynamic country and sector rotation that investors could expect in one of our "traditional" strategies. Crucially, we can choose from a large and liquid proprietary universe of impact issuers, developed during eight years of impact investing in public fixed income markets. We also apply the full scale of our proprietary research to inform our country and security selection, be it insights from our macro or geopolitical strategists or new ESG perspectives. Many of these same insights are also valuable inputs in our impact analysis, thus furthering our dual goals of achieving competitive financial returns and measurable impact outcomes.

Critically, we only invest in liquid public markets, which offers not only daily liquidity to our clients but also allows us to nimbly rotate in and out of areas of the market where we see the most attractive risk and reward.

Finally, as with traditional fixed income, we consider thoughtful and robust portfolio construction to be of paramount importance to mitigate unintended risks and enhance the potential for consistent outperformance over time.

Conclusion

As vital tools for financing, fixed income investments are positioned at the centre of the transition to a greener and more equitable future. We believe impact issuers will play an important role in this secular shift, as investors seek to bridge the gap between financial gains and societal progress. Adding an impact objective can, in our view, enhance the return potential of traditional fixed income portfolios by providing additional diversification as well as new return opportunities. Applying an active research-based lens in combination with top-down fixed income expertise may further increase investors' ability to deploy their fixed income capital in a more rewarding manner.

¹ Compound annual growth rate of 101% over the last five years. 2022 survey of the Global Impact Investing Network (GIIN).

² "How consumers are embracing sustainability", Sustainability & Consumer Behaviour 2022 | Deloitte UK

³ Barclays ESG Quarterly Credit Update Q2 23, 20 July 2023

Disclaimer

For professional, institutional and accredited investors only. Capital at risk. The views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. This material and its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. While any third-party data used is considered reliable, its accuracy is not guaranteed. This commentary is provided for informational purposes only and should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to sell or the solicitation of an offer to purchase shares or other securities. Holdings vary and there is no guarantee that a portfolio has held or will continue hold any of the securities listed. Wellington assumes no duty to update any information in this material in the event that such information changes.

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