Lifting the lid on impact bonds: 5 questions for investors

Over 25 years of investing in impact bonds, we have learned the value of looking beyond labelled green, social and sustainability (GSS) bonds.

By broadening the definition of impact bonds, investors can access a wider range of opportunities to generate positive environmental and social outcomes while pursuing attractive risk-adjusted returns. However, navigating this market requires a nuanced understanding of innovative security structures, evolving standards and project-level impact assessment.

Here, we look at how to define the asset class, explain why we look ‘off-label’, how the global impact bond market has grown, whether impact bonds involve higher credit risk, and the role these instruments can play in an investment portfolio.

1. How are impact bonds defined?

The bond market generally defines impact bonds as labelled GSS bonds that finance projects with positive environmental or social outcomes (or both). These labelled bonds adhere to recognized principles like the Green Bond Principles and offer investors the extra assurances of use of proceeds reporting and third-party verification.¹

We take a more nuanced view and define impact bonds as fixed income instruments that raise capital for projects or activities with positive impacts, either environmental, social or both. We consider a breadth of securities – including asset-backed securities (ABS) and mortgage-backed securities (MBS) – issued by companies, supranational bodies and government-backed entities like local municipalities and state-owned companies. These could be either:

• Use-of-proceeds bonds, where proceeds are directed towards environmental or social projects by the issuer.
• General-purpose bonds issued by companies or entities classified as environmental or social solution providers in their core activities.

Some of these investments have obvious positive environmental and social outcomes; others require a deeper dive to understand the impact.²

Importantly, we consider both labelled and non-labelled bonds across fixed income sectors and activities. Our perspective is rooted in the search for additionality: unlike investments in equities, which are inherently tied to general corporate activities, bond proceeds can be directed towards a pre-defined use and so contribute to a targeted non-financial impact.

2. Why should investors look ‘off label’?

We believe companies that take steps to adapt to and mitigate environmental and social risks have the potential to outperform over time, and we have developed our process to avoid overlooking this potential in non-labelled impact bonds.

Non-labelled corporate impact bonds often provide investors with the opportunity to invest in longer-dated maturities (more than 10 years) and larger deal sizes (more than US$750mn) compared to their labelled counterparts. Labelled bonds often have tenors of six to eight years as the maturity is intended to align with the life of the project being funded. Longer duration allows investors to potentially realize greater returns if the credit thesis plays out as intended.

To effectively evaluate and select non-labelled impact bonds, we employ a multi-faceted approach. This includes conducting thorough issuer-specific research to understand the environmental and social merits of each bond, assessing the impact of financed projects, and maintaining flexibility in labeling sustainable securitizations. We have identified and categorized these bonds based on sustainability-related focus areas, illustrated below.

We include below three examples of non-labelled issuances that we believe deliver impact.

3. Is impact issuance on the rise?

The impact bond investment universe has expanded significantly in recent years, expanding the opportunity set for investors in this asset class. The chart below illustrates the growth of issuance of labelled impact bonds over the past decade. Total issuance of labelled impact bonds topped US$1tn in 2021, though dipped below this threshold in 2022 and 2023 due to factors like investor concerns around greenwashing.⁶ We observe that issuance of non-labelled impact bonds has also grown over the past decade, but measuring that market is more nuanced.

Source: Bloomberg Intelligence

Looking ahead, we see several key trends pointing to renewed growth in the labelled impact bond market, including the emergence of transition bonds and securitized products, a gradual shift in issuance activities from Europe to the Asia-Pacific region in response to investor demand, and large-scale policy initiatives like the US Inflation Reduction Act (IRA).⁷ Thus the tailwinds for sustainable labelled bonds are not limited to one type of label, offering investors ample opportunities for strong relative value alongside various kinds of impact.

4. Do impact bonds involve higher credit risk?

A common misconception is that investors must pay significantly more for impact bonds compared to conventional securities or accept greater risks for equivalent returns. Our experience (and industry research and analysis) suggests that such views are misplaced.⁸

The credit risk for corporate impact bonds is typically the same as conventional bonds, as the coupon and principal are legally deemed to be general obligations of the issuing entity. This is why our due diligence process incorporates a holistic view of corporate issuers and is not just focused on a single bond issuance.

Certain fixed income securities, like ABS or government-issued bonds, have unique features that may enhance or detract from credit quality. For example, investors in US treasury securities are mainly exposed to interest rate risk, while investors in ABS will have exposure to the underlying collateral of the security, which may include a wide range of assets.

We have observed that disclosure, a crucial window into credit risk, varies widely among fixed income sectors, with public corporate issuers generally providing the most comprehensive disclosure and government and private corporate issuers providing the least. A thorough analysis of both material quantitative and qualitative factors, including ESG factors, is necessary to assess credit risk. Our combined fundamental and sustainability expertise enables us to fill in disclosure gaps, enhancing our understanding of each issuer’s material risks and broadening our investment universe.

5. What role can impact bonds play in a portfolio?

Impact bonds can primarily offer three diverse qualities within portfolio allocation.

First, stability: the buy-and-hold nature of many sustainability-focused investors can lead to lower price volatility as these bonds often trade less frequently than conventional securities. Investors that engage in relatively small transactions can remain nimble, however; our team leverages specialized sell-side relationships that allow us to break up larger trades into more digestible sizes and provide sufficient liquidity.

Second, transparency: regular impact and allocation reporting adds a layer of transparency and insight into issuances.

Third, diversification: investors with the resources and expertise to identify investments aligned with sustainability themes can go beyond standard business practices, employing a flexible, multi-pronged approach that examines collateral and use of proceeds in parallel.

A growing and impactful opportunity set

To navigate this expanding but complex market, we believe a nuanced understanding of innovative security structures, evolving standards and project-level impact assessment is key.

Our experienced investment team addresses the complexities of impact bonds by emphasizing due diligence, assessing reputational risk and governance, and ensuring that issuances drive tangible impact. By carefully analyzing both the financial merits and additionality of each investment opportunity, we aim to identify bonds that offer competitive returns in line with the conventional market while delivering measurable environmental and social benefits.

As the impact bond market continues to expand and evolve, we believe that investors who allocate resources and expertise to this area will be well-positioned to generate both carefully considered impact and risk-adjusted returns.

1. International Capital Markets Association, 2022: European Green Bond Principles 
2. In our 2023 Impact Report, we reported that 39% of the issuers in one of our fixed income strategies reported GHG emissions avoidance data, and we were able to estimate GHG emissions avoidance data for about 25% of the portfolio. The remaining 36% of issuers in the portfolio either did not report data, or we were not able to make an estimate. 
3. Xylem, 2023
4. First Help Financial, 2024
5. Women’s Livelihood Bond Series, 2024
6. Labelled impact bonds shown are those with third-party assurances as reported to Bloomberg. The assured impact bond data follows industry standard and is most widely cited across institutions. For our broader Impax universe, we also consider bonds that are not assured, preferring to judge each bond’s impact via our own framework. S&P Global, February 2024: US Muni Sustainable Bonds ↩︎
7. The White House, January 2023: Building a Clean Energy Economy ↩︎
8. Karoui, L., Lynam, A. et al, February 2022: ESG in credit: A costless benefit to portfolios (Puempel), Goldman Sachs

References to specific securities are for illustrative purposes only and should not be considered as a recommendation to buy or sell. Nothing presented herein is intended to constitute investment advice and no investment decision should be made solely based on this information. Nothing presented should be construed as a recommendation to purchase or sell a particular type of security or follow any investment technique or strategy. Information presented herein reflects Impax Asset Management’s views at a particular time. Such views are subject to change at any point and Impax Asset Management shall not be obligated to provide any notice. Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary. While Impax Asset Management has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third-party information presented herein. No guarantee of investment performance is being provided and no inference to the contrary should be made.