Investing in ethical bonds for a better future

Hi, I’m Staci from FundCalibre, and today I’m joined by Bryn Jones, manager of the Rathbone Ethical Bond fund. Hi Bryn.

[00:09] Hi. How you doing?

So, I wanted to start with the portfolio today: over two-thirds is invested in banks and insurance. So, why these sectors? What’s the attraction today for investors and how are these areas ethical from a bond perspective?

[00:28] Yeah, so firstly the fund is a sterling-based fund, and the majority of the sterling bond market is financials, banks and insurers, that’s the lead industry in the UK. So, naturally there would be a focus to towards financials and insurance. 

In terms of their value, right now, since 2008, banks and insurance companies have become more regulated, in particular about their capital and solvency. As a debt investor, we like good, strong solvency because it means that our capital is protected. You look at the banks, for example, prior to GFC [Global Financial Crisis] may have had in the UK, CET1* [Common Equity Tier 1] ratios are somewhere around 5%-7%, and in Europe around 3%-5%, particularly in Spain, where they were very weak. Subsequently, since then, the solvency of UK banks is mid-teens and in some cases in the building societies, in the 20% area. And European banks likewise have reasonable solvency. They are also quite highly regulated in Europe and the UK in terms of liquidity coverage ratios, so having to match their assets and liabilities, something that was a big problem with the regional US banks. So, we quite like the banking sector as a result of that.

[*The CET1 ratio compares a bank’s capital against its assets.]

The insurance sector is very similar in terms of the solvency requirements [which] have increased quite rapidly. And in some cases, you know, they have solvency that’s well above minimum requirements. Take some of the companies like Rothesay [Life Plc] and some of the big, big players and they have solvency of 180% – 250%, which is, you know, excess capital of billions of pounds, again, protecting us as investors. So, we quite like the space from that respect. 

Also, some of the old legacy debt is no longer fit for being used, according to regulatory requirements. So, we can go through the covenants of different bank bonds and work out these bonds can no longer be used for regulatory purposes. And in some cases, there’s significant upside for us as bond holders, for them to take those bonds out. So again, not only are we getting good income, we’re getting some good capital generation from them. 

And in terms of what we think from an ethical perspective, as I said, they are becoming increasingly more regulated. There are many with net zero targets. We only lend to banks which lend out less than 5% of their assets for fossil fuel financing. So, we have a very low weighted average carbon intensity as a result of that. 

Governance is key issue for us. So, we’re often looking at banks and the banks are often put on the, what I call a naughty chair. We quite often see a bank, you know, that’s done something wrong. In particular, Credit Suisse was a classic example. We didn’t like the governance of the bank and we didn’t hold that bond. So, on that kind of sort of screening sense, we do look at the banks and financials quite closely. And I guess just, you know, existentially speaking, you know, without a banking system, there would be social upheaval. You could argue that banks do provide social cohesion. And so, they do effectively provide some kind of sustainable economic model for economies to survive. 

So, that’s why we’re investing in banks and insurers. And of course, insurers – without insurance, for example, if your house blew over, you would have nowhere else to live. And again, that provides social cohesion. So, arguably we do both negative / positive screening and we are applying layers of governance as well as the sustainability for the assets that we own.

And how are you managing the risk associated with higher interest rates today in the portfolio?

[04:14] We’ve been underweight duration. Duration’s an effective way of managing interest rate sensitivity in bond portfolios. We’ve been pretty much underweight duration for two or three years in the interest rate rising environment. And that’s meant that from that portion of the attribution, we’ve outperformed our peers. Yields have risen quite some way and we started to reduce that underweight. So, we’ve been using gilts – in particular, green gilts for the ethical bond funds. The only two gilts we can buy are the 2033 and 2053. Currently, we’ve built quite a large position. It’s now the end of May/beginning of June when I’m speaking. And you know, we built quite a large position in the ‘53 gilt, so this is a 4% position, which is the longest gilt – or longest asset – we’ve bought for a very long time.

We do feel gilt yields have risen. We feel that inflation is still quite sticky in the UK and that might mean that we might get yields rising a bit higher. But at some point, these high yields will start to put pressure on growth, will start to put pressure on earnings. And of course there is expectations as a result of that. If you read some surveys such as Deutsche Bank’s Jim Reid’s theory that we are going to start entering a recession at some point towards the end, back end of ‘23, early ‘24. And if that is the case, you’re going to want to be longer duration. So, it’s a bit of a cat and mouse game. We can’t just sort of go long duration now. But we’ve definitely reduced our underweight duration, with the gilt yields back up above 4%.

And you mentioned earlier governance with the banks, and engaging with them there, but how do you ensure the sustainable nature of all the bonds that you invest in?

[06:04] Well, of course, we have Greenbank which review all our assets before we buy them. So we have a negative and positive screen. You know, of course our fund is an ethical fund. It was launched 22 years ago. I’ve been managing it nearly 20 years. And ethical mandates were in place before UN Sustainable Development Goals were put in place. Of course, sustainability is a key issue. And so, whilst we have a negative and positive screen, so no alcohol, gambling, pornography, you know, completely excluded. We do have a positive screen and that positive screen means it has to have one positive, which would have an impact on environment, society, gender equality, diversity. And so, that’s the kind of binary decision that we have. But also now, as I mentioned, you know, fossil fuel financing is a key issue. So, you know, we’re avoiding the banks which have highest of their assets lent out for fossil fuel financing. 

Governance is a key issue. And part of that process now is the credit analysts’ work. So, whilst we have our binary decision, we also have what we feel is a more qualitative decision that’s given to us by our credit analysts. But not only that, we have a risk team now that also review the bond portfolio for certain metrics such as MSCI ESG scoring to ensure that we don’t invest in any controversial areas. We have reports on what impacts the fund has on UN Sustainable Development Goals – whilst we’re not directly targeting that, we know what impact it is having. There are reports on the weighted average carbon intensity. And so, whilst we have a negative and positive screen, we’re also applying more qualitative data around the edges to ensure that sustainability of the fund is being delivered. 

Of course, the big issue is in the UK what happens with SFDR [Sustainable Finance Disclosure Regulation] and when we know what the guidelines are, we’ll be able to come out more and discuss how the fund approaches that. Our Luxembourg SICAV version of this is currently an Article 8 fund under the SFDR guidelines**.

Great. Well thank you for that; that was very interesting and a good look at the ethical bond market. So, thanks for joining us today.

[08:30] Thank you for your time. Appreciate it.

And to learn more about the Rathbone Ethical Bond Fund, please visit FundCalibre.com and don’t forget to like and subscribe for more weekly videos.

[** An Article 8 Fund under SFDR is defined as “a Fund which promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.”]