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Bag high yields with high ethics via Rathbone Ethical Bond 

Rathbone Ethical Bond Fund that stands out both because of its ESG credentials and performance
February 18, 2021
  • There is not such a wide choice of ESG bond funds as ESG equity funds
  • But Rathbone Ethical Bond could be a good option and has a strong performance record

With the environmental, social, and governance (ESG) investing boom upon us, funds with a sustainable and ethical tilt are flooding into the market. Yet investors are currently better served in the equity rather than fixed income space, where fewer funds are launching and existing ones tend to be relatively new. Morningstar research recently found that half of the 684 sustainable bond funds available in Europe have either been launched or repurposed in the past three years, including 148 in 2020 alone.

As such, finding an ESG fund with a proven track record and investment process may be trickier for investors with a fixed income allocation. This remains a work in progress when it comes to government bonds, where pressing ethical questions can arise and products are only slowly emerging. But in the corporate bond space, one long-running fund continues to stand out, both because of its ethical credentials and performance.

Rathbone Ethical Bond (GB00B7FQJT36) has a long history and an established process. Run by Bryn Jones since 2004, with Noelle Cazalis joining him in 2016, the fund seeks a greater total return than the Investment Association (IA) Sterling Corporate Bond sector average over any rolling five-year period.

The managers assess the economic environment to decide which industries they want to focus on before identifying potential holdings using the “four Cs plus” approach. This process looks at whether managements of companies which have issued a bond have integrity and competence (character), and whether the bond issuer is avoiding over borrowing (capacity). Jones and his team also assess the agreements on a company’s debt (covenants) and can take big bets that differentiate the fund from the market (conviction).

Rathbone Greenbank, the fund provider’s ethical research division, assesses potential holdings against positive and negative social and environmental criteria, while Jones and his team investigate ESG investment themes.

Bonds issued by companies involved in mining, arms, gambling, pornography, nuclear power, alcohol and tobacco are excluded.

The fund ticks several important boxes. When it comes to ESG, the managers focus on a variety of important issues, including social housing and renewable energy. Cazalis recently told investment platform interactive investor that she and Jones would be likely to see more investment opportunities in areas such as renewable projects and green bonds in the future. She added that they avoid backing companies feeding into issues such as biodiversity destruction.

However, the fund continues to stand out on its performance alone, regardless of your views on ESG. With a focus on corporate bonds with a higher yield, the fund can look attractive as an income play. At the end of 2020, after a year in which bond yields had once again been pushed down and dividend cuts had taken their toll on equity investors, Rathbone Ethical Bond had a historic yield of 3.1 per cent.

More generally, performance has stood out: the fund made a total return of nearly 100 per cent in the decade to 12 February, putting it ahead of many of its peers in the IA Sterling Corporate Bond sector. Even when compared with funds in the IA Sterling Strategic Bond sector, some of which focus on corporate bonds, Rathbone Ethical Bond has held up well in both the short and long term.

A focus on defensive characteristics can steer the fund past some of the pitfalls of chasing yield. Late last year, Cazalis highlighted the risk of bond default rates rising – an issue also discussed on pages 20-22 of this week’s magazine. As such, when it comes to high-yield bonds and vulnerable sectors, she pays a good deal of attention to certain company characteristics, including balance sheet strength and how long a business can continue in a “really stressed scenario where consumers are at home and perhaps spending less than they used to”.

As far as fixed income funds go, Rathbone Ethical Bond makes some concentrated bets. The fund has tended to maintain a hefty allocation to financials: 41.5 per cent of its assets were in the insurance sector at the end of January, with 30.3 per cent in banks and 3.3 per cent in financial services. This, in part, reflects a long-running tactic of buying “legacy” tier one financial debt in the expectation that it will need to be bought back and replaced, on generous terms to investors. This is to enable banks and insurers to comply with new regulations.

The fund had 7.9 per cent of its assets in bonds linked to social housing, with much smaller allocations to other categories. As with many bond funds, these allocations are spread across a large number of holdings, with 253 positions in the fund. Similarly, individual positions are relatively small: the biggest holding in the fund, the Lloyds 2.707% 12/03/2035 bond, represented 3.1 per cent of assets as of 31 January 2020.

The fund's managers tend to broadly focus on themes that can drive returns. In the final quarter of 2020 they invested in bonds issued by Spanish windfarm designer Audax Renovables (SPA:ADX) and the UK operation of sustainable Dutch bank Triodos. The team also added to some bonds they expect to do well due to “greater flexible working and 5G opportunities that are set to bed in once the pandemic is over”. These included sterling-denominated Verizon Communications (US:VZ) bonds. Similarly they have focused on the growth in home deliveries, buying into the first green bond issued by logistics property real estate investment trust Tritax Big Box Reit (BBOX).

The team can also make some tactical plays, including “carefully adding” to assets with a high level of sensitivity to interest rates as their yields rise, and selling these once yields fall back. They did this last year when November’s vaccine news caused yields to spike on high duration bonds, buying debt from the likes of the European Investment Bank and Danish renewable energy giant Ørsted (DK:ORSTED), and then selling when prices recovered and yields fell. The team will not buy UK government bonds because of their links to arms deals.

As such, the fund remains a good source of total returns from fixed income, with strong ESG credentials. However, investors buying into it as part of an ESG portfolio should check, as always, that the fund is run in line with their beliefs. Some may feel uninspired by a fund with a strong preference for the financials sector, although Cazalis has noted that the likes of insurers screen very strongly on ESG metrics.

While Rathbone Ethical Bond’s performance and investment process both look impressive, investors should make no assumption that this is a defensive fund. Corporate debt is not a safe-haven asset and can get caught up in equity market volatility. Rathbone Ethical Bond made a small loss in 2018, for example, a year that proved difficult for stocks.

Yet its total returns and ESG credentials have tended to be robust in the longer term. Buy.