Key Trends to Watch in Sustainable Fixed Income

The sustainability-related bond market has boomed in the past two years. In fact, in just the last year, the issuance of green, social, sustainability and sustainability-linked bonds reached $1 trillion in 2021, more than 69% higher than in 2020 ($606 billion), and almost triple the $326 billion in 2019.¹

To make sense of that growth, Morgan Stanley’s fixed-income leaders recently sat down to explore the future of the asset class and why sustainability bonds will become even more integral to environmental, social and governance (ESG) investing. Participating in the conversation were:

• Katie Herr, Morgan Stanley Investment Management’s Investment Management’s Head of Fixed Income Product Strategy;
• Navindu Katugampola, Head of Sustainable Investing;
• Vishal Khanduja, Co-Head of U.S. Multi-Sector;
• and Jeff Mueller, Co-Director of High Yield.

(This Q&A was shortened for clarity.)

Katie Herr: Navindu, you’ve mentioned that fixed income is an asset class becoming more and more compelling for sustainability-focused and, specifically, climate-focused investors. Can you explain?

Navindu Katugampola: Yes, there are three key reasons why we believe this. First is the sheer range of sustainability challenges that need to be addressed, from renewable energy and infrastructure to affordable housing, schools and healthcare—and these projects are going to require financing at a significant scale. Second, the diversity and breadth of the fixed-income market allows us to address these issues through a variety of structures. Finally, we have a unique set of instruments in green, social and sustainability bonds. These bonds give investors tremendous insight into an issuer’s sustainability agenda and how their investments are helping to achieve impact.

Herr: Vishal, let’s turn to performance. How might a sustainable fixed-income approach affect investment returns?

Vishal Khanduja: A portfolio manager’s philosophy and approach to ESG integration is a key aspect of achieving competitive performance. When evaluating fixed-income issuers, we look at ESG information that we believe is financially relevant to their specific industries. Sustainability concerns that apply to a metals and mining company or a money center bank may not be relevant for an IT or energy company, so the weights and relevancy of different types of factors will vary by industry.

Herr: In the high-yield space, large allocations to energy companies are often a concern. Jeff, can you share your views on this?

Jeff Mueller: We are seeing investor preferences tilting toward ESG in the high-yield space. More portfolios are being managed with environmental mandates, including explicit carbon-reduction targets. Although the energy sector gets headline attention, there are a number of other sectors that fall short from an ESG perspective. For instance, materials, metals and mining and utilities compose about 30% of the high-yield market but contribute more than 80% of carbon emissions. It’s important to consider the improvements possible in these areas. And we must be invested to encourage positive change. Metals and mining, for example, is a sector that’s long been excluded from many ESG-focused portfolios. But the world’s path to decarbonization requires copper, which is sourced from mining companies. We’re seeing some mining companies make great strides in improving their environmental impacts in areas like water use and pollution. Investing in these types of companies can help finance the transition to a carbon-neutral economy.

Herr: Engagement is often associated with the equity side of investing. Navindu, can you tell us a bit about the differences in how investors engage with fixed-income vs. equity issuers?

Katugampola: A lot of people think that engagement’s natural home is in equity markets because equity shareholders vote on resolutions that may receive press attention. But most equity investors are buying and selling securities in the secondary market. On the fixed-income side, interactions with issuers often occur in the primary market, when the issuers are raising money themselves. That provides an enormous window of opportunity to talk with issuers and potentially have some influence over how that capital is directed. Plus, the diverse facets of the overall fixed-income market offer engagement opportunities distinct from equities.

Herr: Jeff, what are your thoughts on the high-yield side? Is engagement different there?

Mueller: Engagement has a crucial role to play with high-yield issuers. We can help them focus on carbon reduction or other sustainability issues and, ultimately, help them attract the type of capital that supports these trends. This is important because the focus on ESG will continue to grow in the market. Also, the types of companies we’re engaging are often different from the equity side. In the high-yield market, we tend to deal with smaller companies that value input from a team with a sustainability track record and ESG resources.

Herr: Let’s turn to green bonds—an area that has seen tremendous growth. Vishal, I know Calvert was one of the first asset managers to launch a green bond fund. What are your perspectives on this market?

Khanduja: Impact or labeled bonds, which include green, social or sustainability-linked bonds, are unique in the fixed-income market in that they direct capital to specific projects designed to address sustainability issues. Growth in the U.S. labeled market has been exponential but even more exciting is its potential for further expansion. In Europe in 2021, about 27% of investment-grade new issues and close to 20% of high-yield new issues were labeled. In contrast, in the U.S. in 2021, only 6% of U.S. investment-grade issuance was labeled and only 3% of the high-yield universe. With the potential for growth in places like the U.S., deeper, more-liquid markets and greater diversification opportunities may result.

Herr: When thinking about ESG portfolios, climate concerns keep rising to the top. How does this affect sustainable bonds?

Katugampola: This ties into engagement with issuers. It is our duty as stewards of capital to put pressure on issuers to be ambitious and set targets to combat climate change. Particularly now, there’s increasing scrutiny, and it seems clear that the goal of net-zero carbon emissions is the ultimate destination. Issuers are increasingly specifying that as a target and it’s obvious to us that green bonds will be a tool toward delivering those objectives.