What is an ethical bond?

Earlier this week, we asked, “What is a bond?”. Bond investment is a very complex area of financial services; Julian Parrott, chair of the Ethical Investment Association and partner at Ethical Futures, explains from an adviser’s point of view and delves into ethical considerations.

A bond is a much misunderstood word in the financial world and in its simplest form is used to describe a one-off single premium investment—hence, fixed rate bonds, guaranteed growth bonds, investment bonds and redemption bonds.

For our purposes, we understand the word ‘bond’ to refer mainly to the ‘fixed interest’ asset class that would encompass government stock, supra-national bonds and corporate bonds, which are basically loan notes to businesses and organisations for a fixed period of time.

Essentially, all these investments offer a fixed regular ‘interest’ or ‘coupon’ for the duration of the fixed term issue and the return potential of your full initial capital on maturity.

These are generally, though not always, deemed to be lower risk than equities (stocks and shares) in that the holder usually ranks above ordinary and other equity shareholders in the event of the failure of the business or institution. Additionally, bonds, though tradable, do not tend to experience as much volatility as stocks and shares.

The risk is associated to interest rate movements in the general market throughout the issuance period and the credit rating of the issuer.

From an ethical perspective there are a number of issues to consider:

Does government stock constitute an ethical investment?

In the UK, unlike in many European countries, it is not possible to discern between ‘good’ (e.g., health and education) and bad (e.g., arms and covert intelligence) spending.

Rather, all government spending is funded via taxation and borrowing in the form of National Savings and Investment (NS&I) issues and UK Treasury stock (gilts). We leave it up to clients to consider this option and advise us.

Most screened corporate and strategic bond funds exclude government stock, but a few don’t.

What types of bonds do you invest in?

A primarily negative screen is applied to the selection of issuers. Bond holders do not really have the ability to influence businesses through shareholder engagement, so the only real positive criteria applied are in terms of the activity of the issue or purpose of the loan.

Bond selection

The degree of ethical interest and the associated risk will affect the bond selection process.

Holdings of interest might include social landlord issuers such as the Peabody Trust, the Co-operative Bank, building societies such as Nationwide, and KfW Bankengruppe, a German issuer that has a special responsibility for the sustainable improvement of economic, social and ecological living conditions.

Perhaps in years to come we will be able to invest in UK Green Investment Bank bonds.

Risk is an issue

There are seven UK listed corporate bond funds, and they have quite different selection criteria and approaches to investment risk. Some much more geared towards A & AA (low risk) rated issuers, others willing to go into riskier BB & C and unclassified ratings.

As with equity funds, it tends to be that stricter ethical criteria will move you towards small and medium sized issuers and therefore a higher default and risk rating.

The development of this market is seen as a valuable addition to the screened investment sector, particularly in terms of offering greater choice to income seeking investors.

Further reading:

What is a bond?

Ethical investment: money with a voice

The Guide to Sustainable Investment