The Big Exchange team discuss whether bonds are a good way to diversify a portfolio...
The views expressed herein are those of the author and should not be considered investment advice.
When looking to invest sustainably, many retail investors pick an equity fund first, perhaps because there is more information in the public domain so it can be easier to see where your money is making a positive impact. In comparison, bonds are sometimes overlooked.
However, bonds can play a useful role in building a diversified portfolio. What’s more, there has been a significant increase in the universe of bonds with sustainable characteristics and several funds on the Big Exchange focus on this area. Read on to find out more.
Bonds are issued by a company or a government to raise capital. A bond is a loan to a company or government for a specified time (typically 1-10 years) in exchange for regular interest payments (the coupon). When the bond reaches maturity, the bond issuer pays back the initial sum invested but, until then, the bond can be bought or sold.
The price of a bond will rise and fall depending on many factors such as company or industry news, interest rate sensitivity and inflation. Its yield (which is the coupon divided by price, expressed as a %) moves inversely to price, meaning that when yields rise, prices fall and vice versa. So, even though the coupon is fixed at the time of issue, the yield on a bond can fluctuate over its life.
Historically, bonds have been less volatile than equities (the extent to which they move up and down), and the two asset classes do not always move in the same direction. However, this is not guaranteed and has been challenged in recent years.
An investor with a low appetite for risk may opt for higher exposure to bonds than an adventurous investor who would likely tilt their portfolio more towards equities. Bonds are considered to sit between cash and equities on the risk spectrum; they can fall in value as explained above whereas cash involves no risk to your capital (other than the rare occurrence of bank failures).
It is important to be aware that both equities and bonds have unique advantages and risks. When making an investment decision, it’s essential for the investor to understand the differences to ensure your portfolio composition is suitable to your individual investment goals, time horizon and risk appetite.
A key factor is the interest rate policies of Central Banks. When rates go up, bond yields typically follow, and their prices fall. In contrast, cuts in the bank base rate can present an opportunity to make capital returns if bond prices rise in response.
Another driver is inflation; when expectations are for high or rising inflation, bond prices tend to fall and vice versa. As most bonds pay a fixed coupon, a rise in the cost of living means your income from them has less purchasing power.
In 2022 Central Banks embarked on a policy of aggressive interest rate hikes to combat inflation. This is now having the desired effect and 2024 may bring rate cuts which should contribute to a positive outlook for bond investors if bond prices were to rise in response.
However, some risks do remain. For example, there could be a renewed spike in inflation should conflicts in the Middle East escalate and disrupt supply chains. Interest rates might have to be raised again to bring it back under control as many Central Banks have inflation targets of around 2%.
Another risk is recession (when economic growth turns negative); however, this is usually considered more of a concern for equities as companies may cut their dividends whereas bond coupons are fixed for their life. In our opinion, clear evidence of an economic downturn could prompt Central Banks to reduce interest rates more quickly to support businesses and consumers.
In summary, barring severe or prolonged recession leading to defaults on interest payments or in the worst-case issuer failure) and with inflation contained we believe there is potential for bonds to deliver positive returns.
Although bond investors do not have the same voting rights as shareholders, they can and do engage with bond issuers to encourage commitment to sustainability as well as advocate for positive social and environmental change.
Bonds with sustainable objectives can help drive substantial ESG (Environmental, Social & Governance) improvements and some of the different types are outlined below.
Green Bonds finance projects or activities with positive environmental impacts such as clean energy development and reducing carbon emissions and energy consumption. Examples are wind farms, water purification plants, clean transport, green buildings and infrastructure, sustainable agriculture, and waste management.
Social Bonds finance social projects or activities that achieve positive social outcomes and/or address social issues. These might include affordable housing, education, healthcare, and access to affordable essential services.
Sustainability Bonds finance a combination of green and social projects or activities and may be issued by companies, governments, and municipalities.
Sustainability-linked Bonds are linked to the issuer’s achievement of climate or broader SDG (Sustainable Development Goals) objectives. Progress, or lack thereof, toward the selected targets results in a decrease or increase in the bonds coupon. It is therefore in the interest of the companies issuing these bonds to meet those objectives. Moreover, there are reputational consequences from objectives not being met.
In addition, fund managers may find investment opportunities in ‘unlabelled’ green bonds from issuers inherently aligned to low carbon products and services, such as a renewable energy company. Climate leaders are those companies leading the transition to net-zero carbon emissions in their industries and mindful of any wider environmental impact.
We offer 10 bond funds on our platform with a variety of investment approaches. Ethical bond funds have been around the longest with Abrdn Ethical Corporate Bond launched in 2012. Those with a focus on social aspects of ESG such as CT UK Social Bond and EdenTree Responsible & Sustainable Short Dated Bond (launched in 2013 and 2017 respectively) are also well established.
Sustainability focused strategies are on offer from AB (Alliance Bernstein), Liontrust and Pictet. More recently we have seen the arrival of dedicated impact strategies which aim to take advantage of the specialist opportunities, including labelled bonds with measurable outcomes. We currently offer T. Rowe Price Global Impact Credit, Triodos Sterling Bond Impact, and BlueBay Impact- Aligned Bond Fund.
For an all-in-one multi-asset portfolio, the LionTrust Sustainable Future Managed range of funds offers equity/bond portfolios with allocations for different risk appetites. Finally, our bundles include a selection of equity and bond funds. Please note, fund allocations for bundles are self- managed.
To learn more about how to become a positive impact investor visit The Big Exchange or follow on Instagram, LinkedIn, YouTube, Twitter or Facebook or download The Big Exchange App to manage how you save, invest and spend your money, all from one place.
The views expressed herein are those of the author and should not be considered investment advice.
Please remember that when investing, making money is not guaranteed and your capital is at risk. The value of your fund can go down as well as up. Tax treatment depends on an individual’s circumstances and may be subject to change.
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