Fixed income is one of the two most important asset classes in many portfolios. It often pales in comparison to the stock market, which receives much more attention. Investing in stocks can be a bit like riding a rollercoaster, while fixed income is more like riding a merry-go-round. It's often the place where you put some money aside to safeguard it against potential market crashes. Many investors underestimate the wide variety available within fixed income and the potential this asset class has to generate significant positive impact.
Investments in fixed income are in the form of debts or loans. In most circumstances, investors are paid back over a fixed period of time (or term) at a fixed interest rate. In this book, we talk about loans with a term of one year or more as fixed income, while those of a shorter duration fall into the category of cash alternatives.
Fixed income is viewed as a counterbalance to public equities because it can offer relatively safe investments that are less correlated to the stock market than most other asset classes. These investments are often used to preserve wealth, generate income, and diversify portfolios. Due to the relative stability and predictable income stream of some fixed-income investments, we tend to see individuals who are approaching retirement age shift larger percentages of their total assets into fixed income, while younger people skew their portfolios toward investments that have more potential for capital growth.
It would be a mistake, however, to think that all fixed income is composed of relatively safe investments. This asset class is actually extremely diverse, offering everything from low-risk to highly speculative investments. So it's important to understand what you're buying and where it lands on the risk spectrum. Don't let fixed income's reputation for low risk fool you. You can lose money in this asset class as easily as you can in any other.
In this chapter, you'll learn about the different types of fixed income investments you can make, how bonds work, and values-aligned opportunities you have for this portion of your portfolio. Federal agencies, local governments, and even corporations are using debt to underwrite projects that green our environment, improve water quality, and better the lives of women and girls. Any one of us has the opportunity to support these goals with our fixed-income assets.
The terms “fixed income” and “bonds” are often conflated, which makes many people think they're the same thing. While bonds are the most common type of fixed-income investment, there are other options available. As you think about your fixed-income portfolio, you may want to include some of these products.
Certificates of deposit (CDs) were introduced in the previous chapter because they're available with terms of less than one year and can serve as a cash alternative. There are also CDs with longer terms, which you can purchase from most values-aligned banks and financial institutions. The return you receive will vary based on the prevailing interest rates, which are set by the Fed and the term of the CD. The longer the term, the more you would typically expect to receive in interest.
Loans to CDFIs and CDFI Loan Funds tend to extend beyond one year, which makes them fixed-income investments. They're relatively low risk due to high repayment rates and tend to pay interest in the low single digits.
Similar to CDs, impact notes are debt instruments that you can buy for varying terms, as shown in Table 6.1. They can be purchased through your brokerage firm or, sometimes, online. High-quality notes tend to be relatively low risk. The three organizations described here have invested more than $2 billion apiece, and they all claim they've maintained 100% repayment rates to their investors over their multi-decade histories.
TABLE 6.1 Impact Note Rates
As of Sept 21, 2020.
You can invest in the Calvert note for as little as $20. The Reinvestment Fund has a $1,000 minimum, while the Enterprise Fund requires an initial investment of $25,000. In each case, interest rates depend on the term of notes, which can run from 1 to 15 years. All these organizations track their impact and provide reports at least once per year.
Bonds are the most common form of fixed income. They are debt instruments that have been standardized so they can be bought and sold on public markets. Governments, corporations, financial institutions, and other entities can all issue bonds. Money raised through a bond can be used to underwrite anything from corporate growth to mortgage lending to public goods.
You can choose to buy individual bonds and create your own bond portfolio, or you can invest in bonds by purchasing bond funds, which are single investments that hold multiple individual bonds. Many people do the latter, which simplifies decision-making and provides significant diversification through a few investments.
Bonds represent an emerging, but often overlooked, asset for impact investors. Since many bonds have specific, well-articulated objectives, they can deliver targeted impact and provide investors with transparency into the use of funds.
When an organization decides to raise millions, hundreds of millions, or even billions of dollars with a loan, they may issue a bond and establish its characteristics at that time. The bond is then sold through what is known as a primary market, and the issuer receives the money they intended to raise. At this point, the bond can move to a secondary market, where shares can continue to be traded throughout the life of the bond.
The most important characteristics of a bond are the interest rate (coupon), maturity, face value, and rating. To help you understand these terms, let's consider a $11.3 million bond that was issued by Jackson College in Michigan. This bond was issued to help the college acquire more student housing and improve other buildings on campus.
The issuer of the bond is Jackson College, Michigan, which wanted to raise $11.3 million for campus improvements. This is the organization that's borrowing the money. So it's their obligation to repay.
The coupon is a fancy name for interest rate and is the amount that will be paid to investors each year. In this case, the coupon is 2.50%. Interestingly, the term “coupon” is a convention that goes back several decades. At that time, bonds were physical pieces of paper with coupons attached to them. Investors would cut off a coupon and take it to the bank to receive their interest payments. Fortunately, things are a bit easier today, but the term remains. In most cases, the coupon is established at issuance and does not change over time.
Maturity is the day when the bond term ends. It's the time when the initial investment, or principal, is due to be paid back to investors. Bonds can have short (1–5 years), intermediate (5–10 years), or long (10 years or more) terms. The Jackson College bond in this example matures on May 1, 2044, 24 years after it was issued, which makes it a long-term bond.
Face value is the amount that will be paid to a bondholder at the maturity date, assuming the bond doesn't go into default. It is usually $100 or $1,000. When you buy a bond, you may not pay the face value, because, over time, the price fluctuates based on the prevailing interest rate and other factors. You can always determine how much the price has changed by comparing the current value to the face value. Par is often used interchangeably with “face value.”
Call is another important characteristic of bonds. In many cases, issuers have the right to pay off investors before the maturity date. The call is the date they can exercise that right by “calling” the loan and paying it off in full. In the case of a bond, the call date is specified and associated with a price that will be paid per share at that time. For example, the Jackson College bond could be paid as early as May 1, 2030, at the original par or face value.
A rating establishes the quality of the bond and is set by rating agencies. In this case, we're showing the rating that Moody's, one of three well-known agencies, has provided. The Aa2 rating in Table 6.2 is considered high investment grade, suggesting this bond would be a relatively low-risk investment.
Each bond issuer has a unique purpose for raising money. Sometimes the purpose addresses environmental and social issues, which make those bonds attractive to values-aligned investors. Bonds and bond funds can be found across all levels of impact. They do no harm (level 1) by excluding controversial sectors or companies, benefit stakeholders (level 2) by seeking favorable sectors or companies, or develop solutions (level 3) by supporting specific social or environmental outcomes. Some bond fund managers also engage directly with issuers to influence impact and outcomes. In this section, we're going to focus on the four bond types that are most likely to appeal to values-aligned investors: Treasuries, government agency bonds, municipal bonds, and corporate bonds.
Debt issued by the US government is called Treasuries. As shown in Table 6.3, it comes in the form of bills, notes, and bonds, each of which has a different term, or maturity. The US Treasury issues debt to fund the federal government's mandatory and discretionary spending each year. The Bank of England issued the first government bond in 1693 and used it to fund a conflict with France.4 Similarly, the first bond in the US was used to finance the American Revolutionary War.5
TABLE 6.3 Treasury Bills, Notes, and Bonds
|Bills||a few months to 1 year|
|Notes||2 to 10 years|
|Bonds||more than 10 years|
Treasuries are considered one of the safest fixed-income investments, because they're backed by the full faith and credit of the US government. Investors are virtually guaranteed payment as long as the security is held to maturity. As a result, the interest rate paid on the US T-Bill is often referred to as the “risk-free rate.” Interest rates on other bonds are often established by comparing the issuer's credit quality relative to an equivalent US Treasury. The closer a bond's interest rate is to the rate of a Treasury bond of a similar type, the lower the risk, whereas the further the interest rate is from the Treasury rate, the higher the risk. This difference is known as the “spread.”
There are two types of agencies associated with the US government. Both issue bonds to finance public goods, such as home, small business, and education loans. The US Small Business Administration (SBA) and US Department of Housing and Urban Development (HUD) are federal agencies established by the US government. They represent the first type of agency, and the bonds they issue are backed by the full faith and credit of the US government.
Government-Sponsored Enterprises (GSEs), such as mortgage lenders Freddie Mac and Fannie Mae, were created by the US Congress. However, they tend to be private companies. Although GSE bonds are frequently viewed as low risk, they do not carry the same full faith backing as federal agency bonds or Treasuries. These bonds are often securitized, which means they're backed by homes, automobiles, or other recoverable assets.
State and local government and public entities, such as utility companies, school districts, and hospitals, all issue municipal (muni) bonds. These funds can be used to improve water quality, upgrade roads, build schools, and advance other important projects intended for the public good.
There are two types of muni bonds: general obligation bonds and revenue bonds. General obligation bonds are used to raise money for projects that are backed by the general taxing authority of the issuer, such as roads, bridges, and parks. In general, the interest and principal on these bonds are repaid through taxes and fees. The creditworthiness of the issuer and projected tax revenues are important in determining credit quality and risk.
Revenue bonds are used to fund projects that are tied to a revenue stream. Initiatives related to water quality, utility delivery, and higher education could all be funded this way. Investors are repaid through the revenue generated by the project, such as water/sewer bills, electricity bills, and tuition. Risk relates to financial assumptions, projections, and usage patterns.
The tax-exemption potential should be just one element of your consideration in building a municipal bond portfolio. From a risk perspective, it's wise to hold muni bonds both in your state and outside of your state. For example, since I live in California, I hold several muni bonds that originate there, but I also have bonds from Texas, New Jersey, and North Carolina.
Public and private corporations issue bonds to fund their operations, capital expenditures, and other business needs. A growing number have offered sustainable, social, green, and other impact bonds. Risk depends on both a company's prospects for future revenue and growth as well as the amount of debt it carries. If a company has no other types of debt, then corporate bondholders would be the first lenders to be repaid in a default scenario. However, if the company has other forms of debt that are prioritized, the corporate bondholders may never be repaid. All of these risks are considered in the rating of a corporate bond.
Many people invest in fixed income through bond funds. However, some prefer to own individual bonds as a way of gaining control over their portfolio. This approach can translate into increased values alignment and potentially higher returns. However, it requires more effort and/or more resources than a bond fund strategy.
You can invest in individual bonds on your own or with the help of a financial advisor. Although it's possible to proceed with less, you could need as much as $50,000 to build a diversified bond portfolio. If that's more than you have allocated to fixed income, you might prefer to invest through bond funds.
While it's possible to build your own bond portfolio, the do-it-yourself (DIY) approach requires not only time but specialized knowledge. Bonds can be complicated. They aren't publicly traded like stocks, so you'll need to work with a broker. Unless you're experienced or have an advisor who can get good pricing, you could end up paying too much. You might also incur fees as high as 2.5%. What's more, you'll need to conduct your own research to identify the bonds you want to buy.
With the exception of Treasuries, which you can purchase directly from the US government for as little as $100, bond minimums tend to be in the range of $1,000 to $5,000. In some cases, you have to buy bonds in lots of 5, 10, 25, or 100. Thus, a $1,000 bond could end up costing $5,000, $10,000, or more. For example, a diversified portfolio that held 10 bonds could require an investment of $50,000.
Some financial advisors can build an individual bond portfolio for you. They can identify investments, perform credit analysis, buy and sell bonds, and manage your account. They can also ensure that you are building enough diversification into this part of your portfolio. When I decided that I wanted to own a portfolio of individual values-aligned bonds, this is the approach I took.
During the course of writing this book, I met a financial advisor who specializes in impact bonds. She taught me about the benefits of owning an individual bond portfolio. None of my previous advisors had ever let me know this was even an option. As I realized the potential for cash flow, as well as the increased impact I could have, I hired her to manage some of my fixed-income assets. She selected investments that met my return and values goals and now oversees a portfolio of about 15 bonds for me. I am currently invested in a water treatment facility in my city, an upgrade to an elementary school in southern California, and the Lucille Packard Children's Hospital.
Not all financial advisors will have the interest or skills to help you build a values-aligned bond portfolio. Abacus Wealth Partners, Figure 8 Investment Strategies, Uplift Investing, and Zevin Asset Management were all contributors to this book. These firms are either women-led or have women in leadership positions. All of them offer this service, but investment minimums start at $50,000.
If you have more to invest: For those who have at least $250,000 to invest in an individual bond portfolio, you may want to work with an impact investment firm that specializes in bonds. Breckinridge Capital Advisors and Invesco both build and manage values-aligned bond portfolios, some of which focus on climate change and gender equity. In most cases, you'll work with these firms through your financial advisor. Should you choose this approach, you'll pay a fee to your advisor and another fee to the investment firm.
A World Bank article titled “From Evolution to Revolution: 10 Years of Green Bonds” sums up the current status of sustainable bonds beautifully when they say, “Issued in November 2008, the World Bank's first green bond created the blueprint for sustainable investing in the capital markets. Today, the green bond model is being applied to bonds that are raising financing for all 17 Sustainable Development Goals.”6 Green, social, sustainable, and thematic bonds are being issued by government and corporate entities. The best of breed are guided by a set of green and/or social principles and are validated by third-parties.
Green bonds are used to fund environmental or climate-related projects. They were the first to the party, and they continue to dominate the market. In 2019, a record $258 billion worth of green bonds were issued globally.7 This was a milestone that demonstrates the growing interest in this high-impact class of financial products.
Green bonds can range from very light green to dark green, according to the bond-rating categories established by BlackRock. On the light green end of the spectrum, bonds finance projects that yield only marginal improvements. On the other end, dark green initiatives are expected to result in a long-term, positive impact on sustainable energy consumption. That's quite a span, which is why it's important to pay attention to how bond funds are being used. Just because a bond is referenced as green doesn't make it so.
You can find a wealth of information, including a database of green bonds on the Climate Bonds Initiative website.8 Recently, green bonds have been aggregated into funds, making them easier to access and available to a broader range of investors. As an investor, don't hesitate to ask how proceeds will be used. It's also appropriate to consider the criteria that are being used to select the bonds included in a fund. Green bonds can target several SDGs, including affordable and clean energy (7) and climate change (13).
Since the United Nations estimates that between $2 and $3 trillion per year is required to achieve the SDGs in developing countries alone, there's an urgent need for private capital to address these problems.9 Sustainable bonds are helping to fill this gap. Relatively new entrants to the market, sustainable bonds are pushing beyond pure environmental objectives to also integrate social and economic goals. Governments, corporations, and other organizations are stepping up to the challenge. Verizon is one example.10
Gender-lens investing supports women-led companies, promotes gender equity in the workplace, and finances products and services that improve the lives of women and girls. Although rare, you can purchase bonds that are issued to finance women-led businesses or to foster women's leadership.11 These bonds foster gender equity (5).
Another way to support gender values is by purchasing municipal or social bonds that underwrite affordable housing, healthcare, education, and community services—all of which have an outsized positive impact on women and girls. These types of bonds intersect with a number of SDGs, such as good health and well-being (3), quality education (4), and reduced inequities (10).
Social bonds support projects designed to achieve positive socioeconomic outcomes for target populations. Often these bonds carry a strong gender component and hit many of the SDGs mentioned above. They can also align with sustainable cities and communities (11).
The exponential growth we've seen in values-aligned bonds over the past few years is expected to continue. That suggests we'll see even more opportunities in the years to come—not only in individual bonds but in bond funds as well.
Many investors will enter the bond market via bond funds and ETFs, which can be purchased through public markets. ETF stands for exchange-traded fund, which is a type of financial product that holds a collection of securities such as other funds but is traded more like a stock. A number of these funds have no minimums, which makes them accessible to any investor. There are values-aligned bond funds and ETFs that allow you to have the best of both worlds: simplicity and impact. You can purchase these investments through an investment firm such as Fidelity, Vanguard, and Schwab, a robo-advisor, or a financial advisor.
There is tremendous variety within funds, each of which can hold hundreds or even thousands of individual bonds. You can find bond funds and ETFs that range across sectors (types of bonds), maturity dates, and ratings. To better understand how bond funds work, let's consider two very different values-aligned investments, as shown in Table 6.4.
TABLE 6.4 Bond Comparison
Compiled using Morningstar data from August 31, 2020.
|Coupon range||0% to 2%||1%||22%|
|2% to 4%||19%||46%|
|4% to 6%||76%||13%|
AB Impact Municipal Income (ABIMX) is an actively managed social bond fund. The fund supports solutions in education, water, and mass transit. Given this emphasis, this fund could be approaching level 3 impact. At the time the data in the table was captured, ABIMX held primarily municipal bonds (92%), although there was a slight allocation to corporate bonds (5%) and cash (3%). This is considered a long-term fund, as 79% of the assets fall into that category. ABIMX holds about 150 primarily investment-grade bonds—most of which range between AA and BBB. A portion (14%) are invested in non-investment-grade (NIG) bonds. Interest rates (coupon) paid on the bonds in this fund are in the higher end of the scale, which makes sense given the longer-term maturity schedule and rating choices.
iShares ESG US Aggregate Bond ETF (EAGG) is a passively managed fund that applies ESG screens to invest in government, corporate, and securitized bonds that receive favorable ratings on their environmental, social, and governance practices. This approach places EAGG at level 2 in terms of impact. The fund holds government, corporate, and securitized bonds in fairly equal portions. It's also relatively balanced across coupon range and maturity schedules. The fund has over 2,500 bonds, 95% of which are investment grade.
You might consider investing in ABIMX if you preferred an actively managed fund that is maximizing impact. You could, however, be accepting more risk, because the fund is skewed toward one bond type and includes more lower-grade bonds than EAGG. EAGG might be your choice if you're comfortable investing in bond ETFs and are seeking a high-rated investment with broad exposure across sectors and maturity dates.
The type of data contained in Table 6.4 is easy to find using online tools. You can look up any bond fund or ETF you own to better understand what it holds, the fees you are being charged, and other information. You can also use the tools to analyze investments you may be considering. A video on our companion website will show you how to locate this data for virtually any bond fund or ETF.
Sustainable, green, and other values-aligned bond funds and ETFs that anyone can invest in are relatively new. As a result, the number of investment opportunities is currently limited. What's more, some of these funds have track records of less than three years, which make them less attractive to investors who prefer to see more history. Although the shortened time frame would not stop me from investing, it certainly gives me pause and would cause me to do more diligence on a potential investment. In addition, some of these funds carry loads of 3.0% or more. A load is a fee or commission that is paid when the fund is purchased. I choose not to invest in funds that carry loads because the fees can have a negative impact on my return.
When you remove funds that have short track records or loads from the universe of values-aligned bond funds, it shrinks noticeably. That said, there are still a handful of opportunities for any investor. Unless otherwise noted, the funds in this section have minimums of $2,500 or less and no loads.
Sustainable funds currently offer the greatest range of choice among values-aligned bond funds for the average investor. Funds in this category tend to fall into impact levels 1 and 2, either avoiding certain investments (do no harm) or applying ESG criteria (benefit stakeholders) to determine which bonds are included in the fund. In this category, you can find funds that vary in terms of focus, quality, risk/return profile, and impact. Let's take a look at Table 6.5 to compare sustainable bond funds.
TABLE 6.5 Sustainable Bond Fund Comparison
Compiled using data from Morningstar as of Sept 18, 2020.
|Bond Name||Ticker||1–Yr. Return||3–Yr. Return||5–Yr. Return||Fee|
|iShares ESG 1–5 YR ETF||SUSB||5.57%||3.85%||-||0.12%|
|AMG GW&K Core ESG||MBGVX||7.27%||4.74%||3.88%||0.88%|
|Pax Core Bond Fund||PAXBX||7.09%||4.57%||-||0.71%|
|Pax High Yield Bond Fund||PAXHX||5.89%||4.86%||5.58%||0.96%|
|TIAA-CREF Core Impact||TSBRX||6.71%||4.90%||4.18%||0.64%|
|iShares ESG Corp ETF||SUSC||9.50%||6.42%||-||0.18%|
AMG GW&K Core Bond ESG N (MBGVX) is a level 2 fund that incorporates ESG criteria into its investment analysis. The actively managed fund holds approximately 75 bonds and is heavily weighted to investment-grade US corporate and securitized bonds.
TIAA-CREF Core Impact Bond Retail (TSBRX) is another level 2 fund but is much more diversified than MBGVX. This fund holds over 950 investment-grade US government, corporate, and securitized bonds that demonstrate ESG leadership and/or have direct and measurable environmental and social impact.
Pax High Yield Bond Fund (PAXHX) is a very different fund. A portion of the fund is allocated to companies that drive solutions in automotive efficiency, renewable energy, and sustainable communities. So at least part of the fund is approaching level 3 impact (develop solutions). However, non-investment-grade bonds make up the majority of the fund, as it accepts a higher risk to achieve greater returns.
Note: Although they are all included in the same table, these funds are quite different in terms of the sectors they hold, average interest rates, maturity dates, and ratings—all the characteristics we discussed in the earlier bond comparison example. The same holds true for the other tables included in this chapter. If you were evaluating these funds to make an investment decision, you'd want to use online tools to analyze the features of each bond fund so you'd know what it held, your risk, and the potential for return.
If you have more to invest: Many fixed-income and public equity funds come in share classes. Funds within the same grouping can have exactly the same name with the exception of a letter at the end. For example, Neuberger Berman Municipal Impact A and Neuberger Berman Municipal Impact Inst are basically the same fund. However, one is designed for the retail investor, and the other is created for institutional investors (i.e., pension plans, corporations) and high-net-worth individuals.
Retail funds usually have smaller minimums. Institutional funds, on the other hand, have minimums that can start around $100,000 and go as high as $10 million. In exchange for higher minimums, institutional funds tend to come with the benefit of reduced fees and no loads.
There are some sustainable bond funds that have loads at the retail level but not at the institutional level. For example, Calvert Responsible Income I (CTTIX) is available with a $250,000 minimum, while JPMorgan Municipal Income I (HLTAX) and Neuberger Berman Municipal Impact Instl (NMIIX) both have $1 million minimums.
Green bond funds are even more recent market entrants than sustainable bond funds. Of those listed in Table 6.6, only the Green California Tax-Free Income Fund (CFNTX) has a five-year return history. This actively managed fund invests exclusively in investment-grade municipals, providing tax-free interest. The remaining funds and ETFs are intermediate term and hold a mix of government and corporate bonds from around the world.
TABLE 6.6 Green Bond Fund Comparison
Compiled with data from Morningstar as of Sept 18, 2020.
|Bond Name||Ticker||1–Yr. Return||3–Yr. Return||5–Yr. Return||Fee|
|Green Calif Tax-Free Fund||CFNTX||3.55%||2.55%||2.51%||0.77%|
|iShares Global Green ETF||BGRN||4.67%||-||-||0.20%|
|TIAA-CREF Green Bond||TGROX||7.35%||-||-||0.80%|
|VanEck Vectors Green Bond ETF||GRNB||7.59%||2.72%||-||0.20%|
If you have more to invest: You might want to consider the Franklin Municipal Green Bond Adv (FGBKX), which entered the market in 2019. This muni bond fund has a $100,000 minimum. Mirova Global Green Bond Y (MGGYX), Calvert Green Bond I (CGBIX), and AllianzGI Green Bond P (AGBPX) are green bonds that have loads in the retail class but are load-free at the institutional level for minimums of $100,000, $250,000, and $1 million, respectively.
There's only one fund that I am aware of that specifically targets gender equity. Although it was announced in early 2020, the Artesian Women's Economic Empowerment Bond Fund (WE Fund) was not available at the time of this writing. However, it's expected to be open for investment soon.
For now, the best way to address issues related to women and girls is through social bond funds that deliver affordable housing and support education, improved healthcare, and community development. These interventions have an unusually large and positive impact on women and girls. Some of these social bond funds are compared in Table 6.7.
TABLE 6.7 Gender and Social Bond Fund Comparison
Compiled using data from Morningstar as of Sept 18, 2020.
|Bond Name||Ticker||1–Yr. Return||3–Yr. Return||5–Yr. Return||Fees|
|Access Capital Community IS||ACATX||4.36%||-||-||0.40%|
|AB Impact Municipal Income||ABIMX||3.63%||5.08%||-||NA|
|CRA Qualified Investment Retail||CRATZ||4.45%||3.11%||2.46%||0.82%|
|Columbia US Social Bond Inst||CONZX||4.01%||4.26%||3.96%||0.45%|
AB Impact Municipal Income (ABIMX) invests primarily in bonds supporting education, water, healthcare, and mass transit. With more than 80% of the assets invested in municipal bonds, the interest on this fund is mostly tax exempt at the federal level.
CRA Qualified Investment Fund: Retail Shares (CRATZ) is an investment-grade short- to intermediate-term fund that prioritizes affordable housing, minority advancement, and environmental sustainability. Bonds issued by the US government and government agencies make up the majority of the holdings.
If you have more to invest: You might want to consider the institutional class versions of the bonds listed in Table 6.7. For example, the institutional version of CRA Qualified Investment Institutional (Ticker: CRANX) is available for a $100,000 minimum, while Access Capital Community Investment has an institutional class version with a $1 million minimum.
The universe of sustainable, green, social, and thematic bond funds is relatively small. Innovation seems to happen at the bond level first and then moves into funds. With the acceleration we are seeing at the bond level, we hope to see growth in bond funds, too. Nonetheless, there are some options available now for any investor.
When you invest in bonds there are four key risks you should be aware of: credit risk, interest rate risk, liquidity risk, and concentration risk. Understanding these risks will help you make more informed bond-investment decisions.
The most obvious risk when you purchase any type of bond or fixed-income product is credit risk. Since these investments are loans, there's always the possibility the borrower will default.
This risk can be mitigated through the choices you make related to credit quality. Investments composed of AAA quality bonds are far less likely to default than investments in lower-rated bonds. Your trade-off will be in returns. Higher-quality bonds will be safer, but their returns will be lower.
You can assess credit risk by reviewing the credit ratings the bonds received from rating agencies such as S&P, Moody's, and Fitch. Or you can work with a financial advisor who can perform credit risk assessments directly.
Credit risk can change. If the business fundamentals underlying the borrower's ability to repay shift, the bond's credit rating can deteriorate or improve. If a bond's creditworthiness deteriorates, the bond becomes riskier and investors are less inclined to own the bond, so its price goes down. The converse is also true. When credit ratings improve, the bond is considered less risky, making it more attractive to investors, so the value of the bond goes up.
This risk is tied to fluctuations in the prevailing US interest rate set by the Fed. When you purchase a bond, it has a fixed interest rate (coupon) and maturity date. You'll be paid interest based on the coupon every year as long as you own the bond. That would be fine, assuming all things in the broader economy stayed the same. But that's never the case. Interest rates will fluctuate, and this will affect the value, or price, of your bond. When the prevailing interest rate goes up, the value of your bond goes down. And vice versa.
Assume you own a bond with a 4.0% coupon when the prevailing interest rate is 6.0%. You are—in essence—losing money. If you tried to sell your bond, you'd probably receive less for it than you paid. The fact that there are bonds with 6.0% coupons makes your bond less attractive to buyers. The value of your bond in the market has gone down as has the price that a buyer would be willing to pay for it.
Conversely, if the prevailing interest rate were 2.0%, you'd be doing well with your 4.0% bond. Buyers would be attracted to your bond because they could earn 4.0% from it and would probably be willing to pay a higher price to access that return. Thus, as the interest rates went down, the price of your bond would go up.
Given the long time horizon, there is more uncertainty around how interest rates will change over the life of a 30-year bond, which makes it riskier. As a result, longer-term bonds tend to offer higher returns than shorter-term bonds to incentivize investors to assume this added risk.
Since it's possible to buy short (1–5 years), intermediate (5–10 years), and long-term bonds (10+ years), you can diversify this risk by owning bonds with a mix of maturity dates. This strategy allows you to hedge against periods when interest rates increase as well as when they decrease.
As you've learned, a well-designed portfolio will allocate money across several asset classes to avoid concentration into a single return driver or exposure. It is also wise to diversify within asset classes. Within fixed income, you can also diversify by:
The easiest way to diversify is by buying an aggregate bond fund that holds a range of bond types with different maturity dates. The most difficult approach is building and managing your own bond portfolio.
Liquidity risk relates to your ability to sell your individual bonds whenever you want. Unlike public equities, which you can trade at virtually any time, individual bonds can be more difficult to sell, because there is no centralized exchange like the stock market. The lack of a centralized system also increases the cost of buying and selling bonds. Bond funds and bond ETFs, however, are easier to sell because they're traded on public markets.
This chapter introduced you to the world of fixed income. While there is more to know about bonds, particularly if you're considering buying and selling them yourself, hopefully you are feeling more confident about them and have insight into values-aligned options in this asset class.
Some of you may be wondering how you will translate this knowledge into investment decisions. Here are a few things to consider. If you're saving your money for a major purchase, you might want to invest in low-risk, fixed-income products that safeguard your assets. For those with less than $50,000 allocated to this asset class, an investment in one or more diversified bond funds could be appropriate. Once you have $50,000 or more for this portion of your portfolio, you might be ready to consider investing in individual bonds, assuming that strategy appeals to you. Most investors at this level are likely to remain invested in bond funds, which are easier to manage and offer increased diversification. Those with larger amounts to invest have more choice, including institutional class funds or working with a financial advisor to build an individual bond portfolio.
To demonstrate how these options play out, let's consider the sample investors we discussed in previous chapters and look at the fixed-income choices they might make, as shown in Table 6.8.
TABLE 6.8 Fixed Income Investment Examples
||Jade and her husband will likely need the money they're putting aside for a house in two to three years. As a result, they decided their funds would be safest in cash alternatives or slightly longer-term CDs or notes, like those mentioned at the beginning of this chapter.|
||Anika has $12,000 that she intends to invest in fixed income. She's planning to split the money between two impact bond funds with varying maturities. One will be intermediate term, and the other will be short- or long-term, depending on prevailing interest rates.|
||Ava is allocating $300,000 of her assets to fixed income. Although she has enough to consider individual bonds, she wants more diversification. Ava plans to split her money across three funds with different maturities. Ava is conducting research to select the funds that are the best match for her financial return and impact goals. In addition to considering the funds mentioned in this chapter, Ava is also searching the web and talking to her advisor to find additional impact options.|
||Maria is an accredited investor. She's targeting about 15% of her assets to fixed income. Since she's passionate about uplifting women and girls, Maria has decided to work with her advisor to invest a significant portion of her fixed-income assets in an individual bond portfolio that focuses on affordable housing, education, and other gender-focused initiatives. To increase her diversification, she'll also hold some bond funds.|
Activating your fixed income doesn't have to be that difficult. As with many of your assets, it starts with knowing what you own.
On our companion website, you will find a template and other tools to help you catalog and analyze your current fixed-income investments in terms of return, maturity, and holdings.
Once completed, consider what you learned from this exercise. Are your fixed-income investments currently diversified, or are they skewed to one type of bond, maturity date, or coupon range? Do you want more diversity? Less diversity? Are there other changes you want to make?
Consider starting by picking one investment to shift into value alignment. Think about the type of investment you want to buy to replace it. Would you prefer to replace what you have now “like-for-like” in terms of bond type, maturity date, and so on? Or would you rather use this opportunity to change your allocations?
When you know the type of investment you want to own, you can conduct research to identify the values-aligned products that match your goal.
Your custodian should save records of your old holdings, but be sure to confirm they will do so before you sell. If they don't offer this service, please remember to save your last statements, cost basis, tax information, and other critical data for your records.
Hopefully, that wasn't too hard, and you're feeling great about what your new investment is supporting. Who knows? You might even be ready to shift another fixed-income asset.