Sustainable Investing Provides Solutions. In the current low-interest-rate environment, institutional and private investors alike are having difficulty generating sufficient returns with traditional investments in stocks and bonds.
Stagnating productivity and demographic decline in the Western world, exacerbated by poor policy response to the 2008/9 financial crisis, defined by promoting global economic growth through monetary policy, have resulted in unprecedented high levels of sovereign debt, anaemic growth, and elevated political risk. A sustainable investment approach can provide solutions.
FINANCIAL REPRESSION IS DRIVING DOWN YIELDS
Total debt levels in the Eurozone and the United States have ballooned to about 250% of GDP. Large-scale bond purchases under the quantitative easing programmes of central banks now amount to almost 25% of global GDP, driving down sovereign and corporate bond yields to record lows, even into negative territory.
Repressionary policy rates affect asset prices across the risk spectrum. Falling bond yields drive asset prices up. As a result, stock markets rally with equity valuations reflecting monetary policy more than fundamentals, and investors chase any investable assets, such as real estate, technology start-ups, or collectibles, thus inflating prices further, risking bubbles, and depressing yields.
SUSTAINABLE INVESTING PROVIDES OPPORTUNITIES
In addition, global risks to sustainable development, such as climate change, pollution, scarcity of resources, population growth, rapid urbanisation, forced migration, and geopolitical risks, loom everywhere. These risks render the investment environment even more challenging, yet also create opportunities.
Choosing to look at the world differently than most, sustainable investors identify global risks as a chance to contribute to addressing these challenges with their capital while meeting their investment goals. Secular themes, such as the growth of clean energy, the rise of emerging and developing economies, rapid urbanisation, and the need for infrastructure, offer the most promising long-term investment opportunities. Generally, sustainable investing is defined as an investment approach that integrates environmental, social, and governance (ESG) considerations into the investment process.
Currently, bonds offer neither stability nor income. Investors recognize the uncompensated risk of supposedly safe sovereign bonds of highly indebted nations. Low yields translate into higher duration risk, resulting in yield moves as the main source of total bond returns (or losses). Rather than buying bonds at depressed yields, many investors prefer to profit from the low-interest-rate environment and enhance returns by leveraging their investments at virtually no expense.
Sustainable investors look for alternatives to traditional bond investments which provide steady returns and a low correlation to equities while making a positive contribution to sustainable development.
High investment and maintenance costs for infrastructure assets are a heavy burden on public budgets. As a result, all OECD countries have steadily reduced their level of infrastructure investment in recent decades. The OECD and McKinsey expect that investments of around
USD 2.5-3.5 trillion per year, corresponding to around 3.5% of global GDP, will be needed to maintain and build key infrastructure facilities globally in line with requirements.
Faced with growing populations, insufficient public budgets, and limited tax-raising capacity, a number of governments seek to finance adequate infrastructure facilities with private capital. Today, private investors already hold a significant share of infrastructure assets, mainly in the telecommunications sector, but increasingly also in the power generation and transmission, transport, water and waste sectors, as well as social infrastructure such as hospitals or schools.
The long-term life cycle of infrastructure assets and the generally long-term, predictable stable income generated from them is attractive to investors. Stable returns of 3% to 15 % IRR can be achieved, the level depending on the characteristics of the infrastructure asset, its location, development stage, risk, and market exposure, as well as the type of investment (equity or debt, direct or fund investment). Many infrastructure assets offer inherent inflation protection due to regulation, concession agreements, contracts, or pricing power based on a strong strategic position. While listed infrastructure investments move in line with equity markets, unlisted infrastructure is relatively uncorrelated to equity and bond markets and hence provides diversification.
For long-term-oriented sustainable investors, both the long lifespan of infrastructure and the fact that approximately 75% of the infrastructure that will be in place in 2050 does not exist today, represent important opportunities to make a significant impact on sustainable development while generating attractive returns. Infrastructure that integrates sustainability considerations into a project’s planning, building, and operating phases while ensuring resilience in the face of climate change and other shocks can make a difference: it improves the risk-return profile of infrastructure investments by mitigating risks, creating tangible benefits and opportunities, and reducing emissions and climate risks. Getting the scale of infrastructure development right will be critical in determining whether or not the world locks into a high- or low-carbon growth path.
MICROFINANCE AND DIRECT LENDING
In developing countries, nearly three billion people have little or no access to proper financial services, and more than 60 percent of people do not have access to formal job opportunities. Microfinance enables them to take out loans to build or expand businesses, make savings deposits, and invest in improving their living conditions and the health and education of their children. Microfinance has also been a powerful catalyst for empowering women.
Investments in microfinance have risen more than five-fold in the last 10 years, to over USD 11 billion globally (2015), and continue to experience strong growth. The largest markets are Central Asia, East Asia, South Asia, and Latin America, and over two-thirds of borrowers are women. The majority of funds are provided by institutional investors, followed by public sector, high net worth, and retail investors. They access this market through investment funds and tailor-made mandates from a number of specialised providers. Net returns for fund investors are attractive, with around 3% p.a. and very low volatility, hence providing diversification to a traditional portfolio of investments.
And the outlook remains positive: the economies with the largest microfinance markets are expected to expand at around 4%, more than double the rate projected for the developed world.
Direct lending can be defined as a form of corporate debt provision to companies without the intermediation of banks. Borrowers are usually smaller or mid-sized companies that have difficulty accessing capital at reasonable rates due to the capital constraints imposed on banks by regulators. Direct lending is an important means of financing entrepreneurship and the growth of SMEs at reasonable rates, hence supporting economic development and job creation.
The direct-lending/private-debt industry has experienced strong growth following the financial crisis, reaching over $440 billion in 2014. Typically, funds are provided to borrowers via limited partnership structures, such as private equity funds, which pay the interest collected on their lending to investors. Recently, online lending platforms have emerged that match lenders and borrowers directly, hence reducing administrative costs even further.
Direct lending provides relatively predictable yields (2-8% over Libor rates) with low correlation to equity markets and downside protection when loans are collateralised by real assets. Thus, it represents an attractive investment opportunity for institutional and private investors alike.
ILS can be any type of financial instrument through which the return of principal and the payment of interest are linked to a predefined “trigger” insurance event, such as a hurricane or an earthquake of a specific magnitude. These instruments allow investors to participate in a market that
was traditionally reserved for insurance and reinsurance companies.
For sustainable investors, such investment opportunities focus on the social impact that arises from increased insurance penetration for risks that historically have proven difficult to insure because of their size or complexity. Examples include drought insurance for African countries; hurricane and earthquake protection in small island nations in the Caribbean and Pacific in support of governments’ disaster relief budgets; and the reinsurance of large, often government-sponsored micro-insurance programs, which provide low-income communities around the world with innovative parametric protections against specific risks for pennies of premium. Such investments bolster the resilience of society to catastrophic loss, de-risk public budgets, and support efforts to combat and adapt to climate change while offering attractive uncorrelated returns.
In summary, sustainable investing provides attractive investment opportunities through steady, uncorrelated returns that can replace high-risk, low-return bonds from massively indebted sovereign nations. EG