Fueled by fixed income: Funding a Sustainable Future

Demand for sustainable bonds will need to increase for the energy transition to happen.

While bonds can seem dull, they hold immense potential in creating a more sustainable world. Fixed income will be a key tool as businesses and governments aim to tap into a $4.5 trillion USD annual investment opportunity in the energy transition by 2030.

“You can selectively raise capital through equities, but primary issuance is usually a small portion of money,” says Konstantin Boehmer, portfolio manager and head of Mackenzie Investments’ fixed income team. “The vast majority of the money used to finance the transition will be through fixed income.” The challenge lies in motivating investors to embrace sustainable fixed income as the designated and optimal asset to fund the trillions of dollars needed to achieve net-zero emissions by 2050.

Incentivizing sustainable bonds

There are two sides to the story: companies borrowing money and governments enacting the energy transition, and large-scale institutional and retail investors buying the bonds that will fund it.

Currently, there’s little incentive for companies to issue debt because borrowing rates are at their highest since 2008. Boehmer envisions a world where structural incentives enable governments and companies to issue bonds with lower yields to encourage borrowing. “If you can borrow at 5% to build a new solar plant but 8% for a coal plant, you’ll choose the former,” he explains. “The larger the difference, the more sustainable finance will grow.”

When considering labeled debt, the incentive is the prospect of falling yields, which will then increase prices. While investors would prefer to receive a higher yield, “recent years have shown us that fixed income is not necessarily defined by the prevailing yield,” says Boehmer. “It’s your expectation of where it will be in a year’s time.”

Say you buy a 10-year sustainable bond with a 5% yield that drops to 1% because of demand. You would receive a % gain on that bond, plus that % income for a total of 1%. You could hang onto a regular bond with a 6% yield, but you would miss out on the proposed spread return.

Fixed income gets creative

While green bonds will continue to fund large-scale projects, other sustainability initiatives need creativity to entice investors. Innovation is well underway: Mackenzie worked with the World Bank to participate in the world’s first outcome bond program, the Rhino bond. This bond was created to help increase the dwindling black rhinoceros population in South Africa. Biodiversity loss could significantly impact the global economy, which motivated Boehmer and his team to bring this innovation to Canadian investors.

The return on the bond increases at certain population growth milestones. If the rhino population reaches its target, Mackenzie and its investors receive the maximum interest at maturity. Because there is a risk the rhino population won’t expand as expected, the Mackenzie Fixed Income team has modeled birth rates, and early results have validated the team’s confidence in achieving the largest return.

Mackenzie also participated in a debt-for nature swap nicknamed the “Galapagos bond” issued by Ecuador, which will double the annual conservation funding in the region.

Boehmer and his team are not just buying innovative bonds, they’re actively working with issuers to create products that benefit both the planet and Mackenzie’s investors. They regularly talk to banks and other institutions about potential bond structures and better terms. “When the bond is issued, we know exactly what it is and what we’re going to put into it,” he says. 

Currently, Boehmer is working with financial institutions to develop carbon-linked bonds, where in exchange for a smaller coupon, Mackenzie will receive an incremental return linked to the monetization of carbon credits a business might generate from a project.

 “We are assuming some risk, but if we believe the project will succeed in generating significant emission savings, that could lead to a healthy return for us,” he says. “We’re partnering with transitioning companies because the faster they decarbonize, the more carbon credits they generate, and the more money will be made for all parties.”

A Bright – and Sustainable – Future

Sustainable fixed income isn’t new – green bonds and sustainability-linked loans, which offer issuers a reduced cost of capital if they hit certain ESG targets, have been around for a while. However, with innovative products that help companies borrow at lower rates and provide investors with the potential for strong returns, these securities may be the future of fixed income. It could take time for demand to increase, but Boehmer is optimistic.

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