Originally published 6th November, 2019
How to realize impact investment beneﬁts
Continued growth and innovation present new opportunities to beneﬁt from what impact investing has to offer. In our view, impact investments can drive positive societal and environmental outcomes, improve portfolio diversiﬁcation and risk management, and generate competitive returns.
As the market expands into new ﬁxed income sectors and across more impact themes, so does the portfolio construction playbook and the ability to add value through ESG due diligence. In this article, we’ll cover our ESG ﬁxed income approach and provide examples of impact investments that we’ve invested in and some that we’ve avoided.
Impact Investing Is Growing, and for Good Reason
The growing demand for sustainable ﬁxed income products is driven by investors’ increased interest in ﬁnding solutions that combat climate change and social inequality. Also, there is a growing body of evidence of ESG risk materiality and the recognition that ESG-managed portfolios can offer strong risk-adjusted returns.
While labeled green bonds continue to make up the largest part of the market, at $167 billion, attention is shifting to a broader range of sustainable bonds and loans. Such non-labeled green bonds experienced the most growth in 2018 (Exhibit 1), fueled in part by greater adoption of the UN Sustainable Development Goals (SDGs).
Exhibit 1: Global Sustainable Debt Issuance 2012 – 2018
Casting a Wider Net to Construct Better Impact Portfolios
These are welcome developments, creating new opportunities to achieve impact, generate competitive returns and build more diversified portfolios across a broadening range of fixed income sectors.
As a specialist asset manager with 20 years of sustainable fixed income investing experience, we’ve witnessed, and in some instances helped shape, market innovations firsthand. We launched the first high yield bond fund focused on ESG factors in 1999. Concerning impact investing, we were an early investor in the green bond market, with Bank of America’s first Green Bond transaction in 2010. We also helped smaller organizations such as Envest Microfinance issue impact notes to a broader market. More recently the Pax Core Bond Fund became the sole investor in The World Bank’s first U.S. dollar denominated gender-linked bond.
Drawing on our investment grade and high yield expertise, we believe we can build income-oriented portfolios that better replicate the broader fixed income indexes while avoiding some of the pitfalls and idiosyncrasies of green and impact bond indexes.
For example, traditional green bond indexes have very long durations and heavy sector concentrations. Our team is able to combine labeled green bonds with a variety of other high-impact bonds, such as those from corporate issuers as well as asset backed securities (ABS), to create more diversified portfolios that better match the Bloomberg Barclays Aggregate Bond Index from a fundamental characteristics perspective, while achieving a better sustainability profile on measures such as carbon intensity and exposure to fossil fuel risks.
ESG Analysis & Fixed Income
The transition to a more sustainable global economy provides both risks and opportunities that inform our ﬁxed income investment process. Impax’s ESG framework reﬂects our core belief that this transition will drive growth for well-positioned companies and create risks for those unable or unwilling to adapt, which is why we:
Our definition of impact bonds includes more than green bonds. Specifically, all fixed income securities under consideration for investment are reviewed for impact potential. A security is identified as an impact bond if its use of proceeds is aligned with one or more of the impact focus
areas listed in Exhibit 2. By leveraging the full opportunity set of impact focus areas, we can make an impact on climate change issues, which remain at the forefront of investors’ minds, as well as other issues, such as gender inequality.
Exhibit 2: Eight Impact Focus Areas Most Relevant to the Fixed Income Asset Class
We also believe that ESG analysis is an effective way to identify material credit risks. With a close eye on how sustainability impacts a company’s ﬁnancial outcomes, our process tilts away from issuers that are exposed to higher ESG risks or those operating in industries that are at greater risk when it comes to the transition to a more sustainable economy — for example, energy sector issuers signiﬁcantly involved in the production of high-carbon commodities.
Conversely, we tilt toward companies that we believe understand these key risks and have appropriate policies and procedures in place to mitigate them. We believe these companies, because they are more strategic in their thinking, will incur fewer regulatory challenges and fines and, overall, will be more resilient in the face of change.
Lastly, while engagement is a tool not commonly used by most fixed income managers, it is a key part of our ESG process. As both an equity and fixed income manager, Impax benefits from crossover engagements that add insight and can potentially influence our view of an issuer. And since bondholders are an essential source of financing, company management tends to be inclined to maintain good relationships and have meaningful engagement. The benefits are twofold — engagement helps improve our ability to fully vet ESG-related risks and opportunities, and it can
help improve an issuer’s ESG transparency and performance going forward.
For example, we recently supported a shareholder resolution filed at a large U.S.-based cable company. The resolution sought increased transparency on key sustainability issues. We wrote a letter of support to that company’s investor relations team, explaining that comprehensive sustainability reporting is additive to our standard credit analysis and, in our view, may help stem mismanagement of significant regulatory, legal, reputational and financial risk. Nearly a third of shareholders supported the proposal at the company’s annual meeting, which is a strong measure of support.
Impact Investment Examples
Exhibit 3: Impact Investments Span the Spectrum of Traditional Issuers
The World Bank Gender-Linked Bond
The World Bank gender-linked bond is the ﬁrst U.S. dollar denominated sustainable development
The World Bank gender-linked bond is the first U.S. Dollar denominated sustainable development bond that mobilizes ﬁnancing to address the importance of investing in women to accelerate economic development, reduce poverty and build sustainable societies. Impax leveraged our long-standing relationship with The World Bank to structure this innovative form of ﬁnancing, and the Pax Core Bond Fund is the sole investor in the $4 million, 3-year, AAA-rated security. We view the World Bank’s gender-linked bond as an important step in creating a new ﬁnancing solution to achieve positive social impact and gender equality. Over the past two years, the World Bank Group has invested $3.2 billion in 21 countries toward programs that provide girls with access to quality education and has also dedicated more than $200 million toward operations that address gender-based violence.
We are pleased to have partnered with The World Bank to introduce this ﬁrst-of-its-kind sustainable development bond to the U.S. markets.
Mosaic Solar Loan Asset Backed Securities
Mosaic Solar Loan ABS are securitizations of residential solar loans. Solar loans are relatively new but have quickly become a mainstream form of ﬁnancing used to promote renewable energy use. The decreasing costs of solar panels and the rapid growth in sales of rooftop solar systems have fueled the growth of solar loans.
We see enormous growth potential in U.S. residential solar demand. Increasingly, the demand is driven by legislation that promotes renewable energy. For example, in 2018 the California Building Standards Commission passed a measure on building energy efﬁciency standards that requires all new homes to feature solar panels starting in 2020.
Solar ABS is a relatively new asset class and trades at attractive spreads compared to the benchmark ABS and similarly rated corporate bonds. Despite the specialized nature of this asset class, we believe solar ABS is poised to become a mainstream sector within the securitized markets as it’s an efﬁcient way to ﬁnance climate solutions.
Sustainable Solution Providers
Sustainable solution providers are companies that generate revenues from products or services that address global sustainability challenges. We believe companies that are well-positioned for the transition to a more sustainable economy should possess stronger future earnings, greater resilience to economic challenges and more favorable credit outlooks than companies ill-prepared for the transition, leading to higher risk-adjusted returns.
Here are two examples from the high yield sector.
Terraform Power is a utility company focused on renewable energy that owns and operates a ﬂeet of wind and solar projects. It is one of the few “pure play” renewable energy companies in the high yield universe. Because many companies within the Utilities sector of the ICE BAML High Yield Index are heavy consumers of fossil fuels for electricity production, given the signiﬁcant environmental and regulatory risks associated with fossil fuel combustion, we feel it is important to reduce environmental and regulatory risks by having strong renewable energy representation in the portfolio.
Within the High Yield Building Materials sector, we focus on ﬁnding companies that can help reduce buildings’ energy consumption. As the leading global producer of rooﬁng shingles, Standard Industries may not be an obvious impact investment candidate, but the company has a fast-growing solar rooﬁng product that we believe could be signiﬁcant in the future. The product is very innovative, providing easier installation than traditional solar panels and a large cost advantage to “solar shingles.” Standard Industries enjoys a very strong competitive position and market share, while demand for rooﬁng materials is very stable due to repair and replacement dynamics in the industry.
Beware False Flags
We believe combining ESG and impact due diligence helps us better understand risks and opportunities and avoid certain problematic investments:
We avoided bonds offered by one U.S.-based utility company because of the company’s poor management of toxic emissions and waste. Despite its certiﬁed green label and being one of the largest green bond offerings by a utility, the company’s involvement in recurring coal ash pollution incidents raised questions for us.
We also avoided residential Property Assessed Clean Energy (PACE) ABS which are authorized by local governments and often promoted as a form of energy-efﬁcient ﬁnancing. The residential PACE loans were high interest rate loans typically originated with lax underwriting standards that failed to check borrowers’ ability to repay. Moreover, such loans were often offered to low-income homeowners, and some loans were made for energy efﬁciency projects we would describe as dubious. Even though these securities typically have a certiﬁed green label from a sustainability rating vendor, we have avoided these ABS due to the lack of nationwide consumer protection regulations.
Lastly, bonds from a producer of utility-grade wood pellets were marketed as a “green” opportunity. However, we believe that the environmental beneﬁts of biomass as an energy source have been overstated. A 2015 report from Climate Central, a climate change research organization, found that switching from coal to wood increased carbon dioxide (CO2) emissions at a UK power station by 15 –20 percent for each megawatt produced.
Positioned to Beneﬁt
Impact investing is a relatively new yet fast evolving area of the fixed income market, with an increasingly diverse range of options available beyond labeled “green” bonds. The expanding universe offers new opportunities to build more diversiﬁed portfolios akin to traditional ﬁxed income indexes as opposed to the more limited green bond indexes. That said, not all impact investments are created equally, and a robust ESG research framework can help fully vet the level of impact generated, the embedded credit risks and the risk-return potential.
Our ESG leadership, issuer engagement and expertise positions us to beneﬁt from the continued growth and innovation in the sustainable bond market. Our aim is to generate competitive returns along with positive societal and environmental impact through portfolios well-positioned for the transition to a more sustainable economy.
1According to research company BloombergNEF, the sustainable debt market comprises labeled bonds and loans that ﬁnance projects with green beneﬁts, social beneﬁts or a mixture of both.
2“Green Bonds: The State of the Market 2018,” Climate Bonds Initiative.
3Sustainable development bonds are issued to ﬁnance projects that solve one or more of the 173 Sustainable Development Goals set by the United Nations. These include initiatives to reduce poverty and gender inequality, mitigate climate risk and decrease environmental degradation, and promote peace and justice.
Diversiﬁcation does not eliminate the risk of experiencing investment losses.
Risks The Pax Core Bond Fund yield and share price will vary with changes in interest rates and market conditions. Investors should note that if interest rates rise signiﬁcantly from current levels, bond fund total returns will decline and may even turn negative in the short term. Mortgage related securities tend to become more sensitive to interest rate changes as interest rates rise, increasing their volatility. There is also a chance that some of the fund’s holdings may have their credit rating downgraded or may default.
The Pax High Yield Bond Fund can invest in “junk bonds,” which are considered predominately speculative with respect to the issuer’s continuing ability to make principal and interest payments when due. Yield and share price will vary with changes in interest rates and market conditions. Investors should note that if interest rates rise signiﬁcantly from current levels, bond fund total returns will decline and may even turn negative in the short term. Mortgage related securities tend to become more sensitive to interest rate changes as interest rates rise, increasing their volatility. There is also a chance that some of the fund’s holdings may have their credit rating downgraded or may default.
About the Indexes
The Bloomberg Barclays US Aggregate Bond Index is a broad base index maintained by Bloomberg L.P. often used to represent investment grade bonds being traded in United States.
The ICE BAML High Yield Index tracks the performance of below investment grade, but not in default, U.S. dollar denominated corporate bonds publicly issued in the U.S. domestic market and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.
One cannot invest directly in an index.
The top 10 holdings of the Pax Core Bond Fund as of 09/30/19 are as follows: United States Treasury Note, 3.375%, 11/15/48 4.6%; United States Treasury Note, 2.625%, 2/28/23 4.3%; United States Treasury Note, 2.750%, 9/30/20 2.4%; United States Treasury Note, 2.125%, 11/30/23 2.2%; United States Treasury Note, 0.375%, 7/15/27 1.5%; United States Treasury Note, 4.500%, 2/15/36 1.4%; United States Treasury Note, 4.375%, 11/15/39 1.2%; United States Treasury Note, 3.500%, 2/15/39 1.1%; United States Treasury Note, 2.250%, 3/31/26 1.0%; United States Treasury Note, 2.375%, 3/15/21 1.0%. Holdings are subject to change.
The top 10 holdings of the Pax High Yield Bond Fund as of 09/30/19 are as follows: Altice France Sa, 7.375%, 5/1/26 0.9%; Hat Holdings I LLC, 5.250%, 7/15/24 0.8%; Fly Leasing, Ltd., 6.375%, 10/15/21 0.8%; Air Canada, 7.750%, 04/15/21 0.7%; Parkland Fuel Corp., 6.000%, 4/1/26 0.7%; Cco Holdings LLC, 5.375%, 6/1/29 0.7%; Tempur Sealy International, Inc., 5.500%, 6/15/26 0.7%; Williams Scotsman International, Inc., 6.875%, 8/15/23 0.7%; Kar Auction Services, Inc., 5.125%, 6/1/25 0.7%; Prestige Brands, Inc., 6.375%, 3/1/24 0.7%. Holdings are subject to change.
The statements and opinions expressed are those of the authors of this report. All information is historical and not indicative of future results and subject to change. This information is not a recommendation to buy or sell any security.Paragraph
Senior Fixed Income Analyst, Pax Core Bond Fund, Assistant Vice President
Sustainability Research Analyst, Impax Asset Management LLC
Impax Asset Management LLC, formerly Pax World Management LLC, is investment adviser to Pax World Funds.
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