What Are ESG Bonds? | The Motley Fool (2024)

Environmental, social, and governance (ESG) bonds benefit investors as traditional bonds do, with the added appeal of funding positive change in the world. These debt instruments attract income investors who appreciate low volatility and the opportunity to put their money toward the greater good.

Let's explore the landscape of ESG bonds, including what they are, how they're used, and how you can add ESG debt securities to your investment portfolio.

What they are

Understanding ESG bonds

An ESG bond is a debt security that funds an environmental, social, or governance goal. For example, a municipality can issue ESG bonds for community development projects, or a corporation might use them to fund solar energy projects, waste reduction, or other environmental targets.

As with any debt security, the issuer of an ESG bond is a borrower, while the investor or bondholder is the lender. The issuer pays the bondholder interest at specified intervals, and the rate is often fixed. When the bond matures, the issuer repays the principal, and bondholders get their money back.

Two additional points:

1. ESG bond issuers can be corporations, municipalities, or governments. The same is true for traditional bonds.
2. ESG bond buyers are largely institutional investors. Retail investors also have access, primarily through ESG bond exchange-traded funds (ETFs), popular choices for sustainable investing portfolios.

ESG and traditional bonds generally provide stability and income within an investment portfolio. Bonds' repayment terms don't change, and their values don't fluctuate like stock prices. However, bond values can rise or fall in response to changes in prevailing interest rates.

According to Bloomberg, "impact" bond issuance totaled more than $939 billion in 2023. That's up 3% from the prior year and down slightly from 2021's $1.1 trillion issuance total. The Institute of International Finance reports that global ESG debt had eclipsed $6.5 trillion by mid-2024.

How to use them

How ESG bonds are used

ESG bonds fund sustainability efforts. The bond can be issued to pay for specific projects or for general use. The purpose is established before bond issuance, so investors can choose how to deploy their funds. An ESG bond's purpose also dictates how the bond is categorized. Investment research firm MSCI (MSCI 0.39%) and others define four types of ESG bonds:

1. Sustainability bonds: Proceeds fund projects with positive environmental or social impacts.
2. Green bonds: Proceeds are used to pursue defined environmental projects. Climate bonds and blue bonds are in this category. Climate bonds fund climate change solutions and renewable energy transition projects, while blue bonds pay for marine-related projects such as sustainable fisheries.
3. Social bonds: Proceeds pay for defined projects with social implications, such as efforts to increase affordable housing.
4. Sustainability-linked bonds: Proceeds can be used for general purposes, but the coupon rate is tied to sustainability targets. If the issuer fails to reach the targets, it will owe bondholders an additional rate.

Pros and cons

Pros and cons of investing in ESG bonds

The advantages of investing in ESG bonds include:

• Higher ratings: Standard & Poor's and Moody's (MCO -0.37%) may rate ESG bonds higher than bonds with similar risk profiles because ESG issuers tend to be more transparent than their non-ESG counterparts.
• Lower risk: An MSCI study concludes that bond issuers with higher ESG ratings tend to outperform lower-rated issuers on cash flow and frequency of severe incidents.
• ESG transparency: ESG bond issuers may provide additional reporting or third-party verification of fund allocation and desired bond outcomes. Extra reporting is not required by regulators, however.
• Stable returns: ESG bonds provide stable returns in the form of interest payments. The interest payments will arrive on schedule unless the issuer defaults or refinances the debt. In a refinance, the bondholder principal is returned.
• Impact investing: ESG bond investors can choose to support projects that align with their personal values.

The disadvantages of ESG bond investing are:

• No reporting standards: While companies may voluntarily report according to International Capital Market Association (ICMA) standards or provide third-party compliance reporting, the U.S. Securities and Exchange Commission (SEC) does not require standardized ESG reporting. Note that the SEC adopted ESG reporting rules for equities in 2024, so a separate ruleset for bonds may follow.
• Lower interest rates: Lower-risk ESG bonds will pay lower interest rates.
• Reactive to market interest rates: Bond pricing on the secondary market responds inversely to market rate changes. When rates fall, bond values rise and vice versa.

How to invest

How to invest in ESG bonds

Investors can purchase ESG bonds directly from investment dealers, online brokerages, wealth management advisors, and other financial institutions. Alternatively, it may be simpler to invest in an ESG bond ETF.

ESG bond ETF portfolios can be broad or specific. Some focus on U.S. investment-grade, corporate bond issuers, for example, while others might offer worldwide exposure across corporate and government issuers.

The process for ESG bond investing is as follows:

1. Contact your investment service provider or advisor and make sure you have access to bonds and/or ETFs.
2. Define your investment goals, budget, and timeline. Remember to keep the big picture in mind. Plan on investing for the long term and holding bonds to maturity for the greatest returns.
3. Identify the available securities that suit your needs.
4. Purchase ESG bonds or ETFs according to your desired asset allocation.
5. Rebalance periodically to maintain your target allocation.

Should I invest?

Should you invest in ESG bonds?

ESG bonds provide lower-risk, reliable returns and often transparency relative to how the proceeds are used. However, the yields can be lower than non-ESG bonds. Whether that tradeoff is acceptable hinges on your values and investing goals.

The decision doesn't have to be all-or-nothing, of course. Your portfolio should include assets with a range of risk-adjusted returns, and your exposure to ESG bonds is only one piece of a greater whole. If you love the idea of funding sustainability-related projects in exchange for interest income, you can find an ESG bond position that supports your larger pursuit of financial returns.

Investing in them

What is ESG investing?

ESG investing is a strategy that considers a company's ESG risks in making investment decisions. It may also be called sustainable investing.

Why is sustainable investing important? Advocates argue that corporations must do more than seek profits. They have the added responsibility of creating positive outcomes for people, communities, and the planet.

Some studies show that doing so contributes to profit-making. For example, companies with strong ESG records showed greater resilience than their counterparts in the market downturns of 2008 and 2018.

Investors are supporting ESG-forward companies and ESG funds, both for the returns and the positive impact. According to a 2021 Morgan Stanley (MS 1.67%) survey, 79% of all investors and 99% of millennial investors are interested in sustainable or ESG investing.

Risks

What are ESG risks?

Poor governance, unsafe or unfair labor policies, data security issues, fossil-fuel dependence, water scarcity threats, and carbon-intensive business practices are all examples of ESG risks that can threaten a company's long-term profitability.

On the other hand, companies actively engaged in creating transparent governance policies, ethical labor practices, alternative energy production, or reduction of waste and emissions are managing those long-term risks to support future stability and growth.

Investors can gauge a company's ESG risks through the widely used ESG rating systems from MSCI USA or Sustainalytics. These ESG rating frameworks help investors evaluate and compare a company's ESG vulnerabilities. For climate-specific information, MSCI ESG research also includes a company's projected contribution to climate change.

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Examples of companies with high ESG ratings include technology companies Microsoft (MSFT 0.84%), Apple (AAPL -0.12%), and Samsung Electronics (SSUN -0.44%). Software companies Adobe (ADBE -8.47%) and Intuit (INTU 1.38%) also score highly.

Across sectors, retailers Best Buy (BBY 0.72%) and Tractor Supply Company (TSCO 1.24%) and companies such as Vestas Wind Systems (VWDRY 3.65%), Enphase Energy (ENPH 3.85%), and Consolidated Edison (ED 1.13%) are ESG leaders because of their focus on renewables.

As a subset of ESG, investors can also choose to invest in conscious capitalism companies, such as Costco (COST 0.11%) and Starbucks (SBUX -0.71%), which prioritize an ethical approach to making money.

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