The Ethical Investor: Amid recent turmoil, should bonds hold appeal to ESG investors?

Bond yields have fallen sharply amid speculation of aggressive Fed rate cuts
Government bonds are favoured for stability and low risk
So should government bonds appeal to ethical investors?

US Treasury bonds have been surging (yields slumping) in the past week or so as weak US jobs data fuelled speculation that the Federal Reserve might aggressively cut interest rates to prevent a slowdown.

Last Friday, the 2-year Treasury yield dropped sharply by a massive 31 basis points to its lowest level since May 2023.

The drop in yields across all maturities reflects growing concerns about a potential recession in the US.

Traders are now pricing in the possibility of more than a full percentage point of rate cuts by by year-end.

“The market is starting to think the Fed is too late in cutting rates,” said Tony Farren at Mischler Financial Group.

While these recent developments have kept investors busy, they have raised concerns about whether government bonds should appeal to ethical and ESG investors.

Before we get into that, a quick primer on bonds

Treasury or government bonds are viewed differently from corporate bonds, which generally carry more risk.

Treasury bonds benefit from the strong credit backing of the government, while corporate bonds are subject to the risk of default of the company.

Therefore, investors demand higher yields on corporate bonds to compensate for risk compared to the near-zero risk of government bonds.

So in this article, we are specifically talking about government-issued bonds.

Why buy government bonds?

Also ahead of delving into the ethical side of things, let’s examine why investors might opt for government bonds in the first place.

Government bonds can play a crucial role in investment portfolios for several reasons.

First, they are generally low-risk and provide a stable income stream, making them a reliable choice for investors seeking steady returns.

Including government bonds in the portfolio helps diversify risk because they typically don’t move in sync with stocks.

They are also highly liquid most of the time, meaning investors can easily access cash or adjust their portfolios.

Additionally, government bonds can help preserve capital during market downturns.

Due to these benefits, government bonds often play a key role in balanced investment strategies such as the 60/40 portfolio.

However, it’s worth noting that while developed market bonds are stable, emerging market government bonds offer the potential for higher returns but come with increased risk and less stability.

Why should ethical investors buy government bonds?

Many experts see government bonds as a strong option for ethical or ESG investors because governments play a key role in creating and enforcing laws on environmental and social issues.

While investors can encourage companies to improve their practices, governments have the power to implement legislation that drives significant change.

Governments are crucial in tackling major challenges such as reducing carbon emissions and fighting poverty. For example, countries with aggressive climate action plans show a commitment to these issues.

Ethical investors can use these indicators to gauge how well different governments align with their values.

By investing in bonds from nations with strong environmental and social policies, and steering clear of those with weaker records, investors can support governments that are addressing global challenges.

This approach allows investors to align their investments with their values, while enjoying the stability and safety that government bonds offer.

Portfolio manager Stuart Chilvers at the Rathbone Ethical Bond fund admits that evaluating government bonds from an ethical standpoint is complex, with differing opinions in the industry.

Chilvers says that while many governments spend on military and controversial industries, they also make significant positive impacts through environmental regulations and social programs.

“…We believe this [military spending] needs to be considered alongside the significant positive impact that many governments have on the environment and society, whether this be through environmental regulations, or spending devoted to education,” noted Chilvers.

Other experts in the industry, such as Australian-based Betashares, believe government bond investing and ethical investing can go hand in hand.

“Bonds are favoured for their inherent long-term income stream, which aligns neatly with responsible investing’s similarly durable view,” said the note from Betashares.

Different types of green bonds

Betashares added that sustainable bonds, green bonds and social bonds allow ethical investors to back critical societal projects.

Since the issuance of the first green bond in 2007-08 by the World Bank, the ESG bond market has expanded significantly.

By 2022, total ESG bond issuance had exceeded US$3 trillion, although this still represents only about 3% of the global bond market.

In June this year, the Australian government launched its first ever sovereign green bond, raising $7 billion.

This bond is expected to support Australia’s role in the global energy transition, and create new job opportunities nationwide.

Given the strong interest, with more than $22 billion in bids from 105 investor institutions worldwide, it’s crucial for investors to understand the green bond market, which encompasses various types of sustainable bonds.

Green bonds

Green bonds are bonds specifically earmarked for financing or refinancing projects that support environmental sustainability. Eligible projects include renewable energy, energy efficiency, clean transportation, eco-friendly buildings, wastewater management, and climate change adaptation.

Social bonds 

Social bonds are used to fund or refinance projects that aim to achieve positive social outcomes or address social issues. These include initiatives related to food security, socio-economic development, affordable housing, access to essential services, and basic infrastructure.

Sustainability bonds 

Sustainability bonds are used to finance or refinance a mix of green and social projects, combining elements of both green and social bonds into one security.

Sustainability-linked bonds

Sustainability-linked bonds are tied to specific climate or environmental goals. The bond’s interest rate is adjusted based on the issuer’s progress toward meeting these goals.

How can Aussies buy green or plain vanilla bonds?

You can buy or sell Australian government bonds on the ASX in the same way you buy or sell ASX-listed shares. Bond trades are cleared by ASX Clear and settled through CHESS.

Note that you can only buy them through licensed ASX brokers. Therefore, you need to have a broker-sponsored CHESS account to buy and sell these bonds.

Additionally, banks can often offer government bonds to their customers, so investors can enquire about purchasing them at their bank.

Investors could also choose to invest in managed funds or exchange-traded funds (ETFs) that include government bonds, offering indirect exposure.

On the ASX, bonds-focused ETFs include:

Vanguard Australian Government Bond Index ETF (ASX:VGB),
BetaShares Australian Government Bond ETF (ASX:AGVT),
SPDR S&P/ASX Australian Bond Fund (ASX:BOND), and
iShares Core Composite Bond ETF (ASX:IAF).