Is Your Fixed Income Portfolio Incandescent or LED?

By Greg Bassuk, Chief Executive Officer, AXS Investments

LIght Bulb iStock-1159017999

Do well with higher yield and do good with sustainable investments

Traditionally, when investors evaluate high-yield bonds, they measure the potential return or yield by their risk tolerance on a potential default, or the duration needed to achieve the income objective. But times are changing.

A longtime institutional investor solution has become an increasingly popular high-yield strategy for individual investors, and presenting a particularly unique proposition against the backdrop of today’s historically low interest rates. By combining high yield returns with strong environmental, social and governance (“ESG”) metrics, investors can achieve two symbiotic benefits: generating greater income and having a more meaningful influence on corporate practices.

Bonds versus equity influence

In contrast to equity holders, high yield bondholders typically face a unique challenge given the nature of their investments,. These investors don’t own shares or build large enough stakes to acquire board seats. Therefore, they lack a direct mechanism to influence company practices or business models.

Risks linked to corporate succession, labor standards and a vast range of ESG factors can impact the price of corporate debt. One of many advantages to investing in corporate debt of ESG-friendly companies is encouraging better ESG behaviors and promoting reporting and disclosures. Investing in corporate bonds of ESG-sensitive corporations promotes a greater adoption of these standards by directing capital toward companies that already have strong scores.

In addition, companies with strong ESG scores have more robust and sustainable business models, which reduces the risk of defaults on their corporate debt, compared to ESG-weak companies issuing high yield bonds.

Bond fund managers who know how to perform thorough ESG due diligence can spot, and sometimes guide, the companies who are on the right track to improve their sustainability standards. They don’t view it as a binary exercise of including and excluding issuers based on industry sector or other overly simplistic measures.

High yield minus high risk?

As the discussion around ESG continues to center around climate change, diversity and inclusion, and corporate transparency, one question constantly reemerges: must investors sacrifice performance in order to integrate ESG into their portfolios?

New evidence suggests that they do not. It may sound like a paradox that high yield investors can achieve lower risks. However, as some of the largest pensions, endowments and foundations have discovered first-hand through their investments, allocating to high yielding corporate bonds issued by companies with sustainable business models can fuel meaningful declines in a high yield portfolio’s risk profile.

Other key benefits inherent in such strategies include direct exposure to ESG holdings, interest rate risk control, shortening the duration of the yield outcome, and reinvestment risk control.

What it means for investors

The time to move fixed income allocations into more ESG-friendly solutions is now. It’s analogous to evolving from incandescent bulbs to more sustainable, efficient lighting options, like LEDs. While equities have gotten most of the ESG attention in the early years of the responsible investing movement, the light is increasingly being shone on bond portfolios.

The benefits are obvious: Higher income mixed with lower risk. In addition, the ongoing trend of greater investments in these ESG-friendly corporate bonds will incentivize other less sustainability-focused companies to improve their ESG outcomes in their pursuit of attracting investment capital.

With more investments options available today than ever before, investors should explore strategies that do not sacrifice performance in any market condition. Instead, ESG and high- yield opportunities challenge the status quo and deliver real value to investors.

Start by thinking differently about the high yield bond market and incorporate ESG into your fixed income strategies.

Opinions expressed are those of the author and are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. There are risks involved with investing, including possible loss of principal. Past performance does not guarantee future results.

There are risks involved with investing, including possible loss of principal. Past performance does not guarantee future results. ESG - Environmental, social, and governance (ESG) criteria are a set of standards for a company's operations that socially conscious investors use to screen potential investments. While the Sub-Adviser believes that the integration of ESG analysis as part of the investment process contributes to its risk management approach, the Fund’s consideration of ESG criteria in making its investment decisions may affect the Fund’s exposure to risks associated with certain issuers, industries and sectors, which may impact the Fund’s investment performance.