Invest in your values: Making an impact through U.S. fixed income

Impact investing has gained a great deal of attention, as of late, as a way for investors to pursue investment returns while supporting an array of social and environmental missions. Impact investors pursue the “double bottom line” of investment performance in tandem with tangible, quantifiable mission-aligned benefits.

The field of impact investing is rich with creativity and enthusiasm. However, it can also strike institutional investors as too abstract and cumbersome to implement in a portfolio.

In a survey taken early in 2014 by J.P. Morgan and the Global Impact Investing Network, impact investors identified a number of difficulties. The greatest challenge to the growth of impact investing, according to the survey, was the “shortage of high-quality investment opportunities with track record,” with “difficulty exiting investments” cited as another key problem. As investors found in the financial crisis of 2008-'09, it can be easy and expensive to underrate liquidity.

Impact investments are available across a spectrum, with illiquid, unique private transactions at one end and liquid, transparent, publicly traded high-quality transactions at the other. Investors would benefit from looking more closely at the latter end of the spectrum.

Within impact investments, some security types have high credit ratings, long track records, liquid markets and availability without entrance and exit restrictions. These security types can help investors make a measurable impact in affordable housing, health care, education and other areas. These security types can be a way for institutional investors new to the impact space to try it out with familiar securities. For seasoned investors, these security types might be an additional way to make an impact and might fit operating accounts, bond proceed accounts and other accounts that are not commonly associated with impact investing.

Financial theory maintains that limiting the size of an investment opportunity set requires a sacrifice in returns. However, if an investor is creative and opportunistic, there is not necessarily a trade-off between investment performance and mission-aligned results.

Some impact security types provide stability in times of financial duress and demonstrate advantageous convexity characteristics relative to their non-impact counterparts. For example, impact mission-aligned agency commercial mortgage-backed securities have a track record of performance that is competitive and substantially less volatile than generic CMBS.

One straightforward approach to impact investing starts with the kinds of U.S. fixed-income portfolios that most institutional investors already have. To implement this approach, investors can make one or more of the following portfolio changes: replace generic agency mortgage-backed securities with impact agency MBS; replace Treasuries and agencies with impact agency CMBS; or replace investment-grade corporates with impact taxable municipals.

The security types used in this approach have the following traits: liquidity; high credit quality; lengthy track records; lower levels of expected volatility than many generic security types; stable cash flow characteristics; scalability; and availability without restrictive entry and exit conditions.

The portfolio also has a range of security types that can be used to support several impact-related outcomes including: affordable rental housing; affordable homeownership; health-care facilities in underserved areas; supportive care facilities for the disabled; eldercare; public/charter schools, overall and in disadvantaged urban and rural areas; access to higher education; economic and job development; community development activities in areas of particular interest to the investor; and brownfield development, i.e., cleaning up polluted areas for new construction.

This approach is illustrated with the Barclays U.S. Aggregate Bond index, but applies to U.S. fixed-income portfolios with other benchmarks as well, since the adjustments involve widely used fixed income sectors.

First, by shifting from the standard agency MBS represented in the Barclays Aggregate to customized impact agency MBS, institutional investors can add a social impact dimension to their portfolios.

Impact agency MBS' mission-oriented mortgage-backed securities are an option for investors who want to support low- and moderate-income families; access to affordable housing; and homeownership in communities identified by the investor.

An investment manager can customize agency MBS and thereby choose to work with lenders who are committed to non-predatory lending practices. If an investor's mission has geographic and/or economic parameters, those can be applied to customized pools. Furthermore, these pools are a way for impact investors to demonstrate to the market that they believe providing capital to low- and moderate-income borrowers is important, safe and profitable.

Agency MBS are backed by the full faith and credit of the U.S. government. The average trading volumes in the agency MBS market can rival the liquidity of U.S. Treasuries. In times of stress, the liquidity of the MBS market has rivaled U.S. Treasury and agency debt.

Second, institutional investors can look at shifting the allocation to impact agency CMBS from the U.S. Treasury and agency debt represented in the Barclays Aggregate. This change can support the following missions:

• affordable rental housing for low- and moderate-income families;


• availability of health-care facilities in underserved areas;


• supportive care facilities for the disabled;


• well-being of the elderly; and


• well-being of areas specified by the investor.

Mission-aligned agency CMBS can primarily be found in securities from the Federal National Mortgage Agency's Delegated Underwriting and Servicing and Government National Mortgage Association project loans.

For investors, the Fannie Mae DUS bonds offer a number of attractive characteristics including full credit backing of the agency; good liquidity; stable cash flows; and strong call protection.

GNMA project loans are backed by the full faith and credit of the U.S. government. The project loan program aims to provide affordable housing and build strong communities through the development and renovation of apartment buildings and health-care facilities. Investors who are proactive and knowledgeable about a community can have an edge finding GNMA project loans that align with their missions. An investment manager can work with an investment bank to select GNMA loans with the type and location of projects that make the desired impact.

Compared to the Barclays Aggregate's Treasuries and agency debt securities, agency CMBS require more expertise from an investment manager. Agency CMBS earn a higher yield because they have more complex structures. They also have fewer market participants.

Third, by replacing the investment-grade corporate bonds represented in the Barclays Aggregate with select taxable municipals, investors can align their portfolios with missions that support:

• Affordable housing


• Access to higher education


• Public schools, overall and in disadvantaged urban and rural areas


• Economic and job development


• Brownfield development


• Eldercare

The taxable municipal market is less liquid than investment-grade corporate bonds, U.S. Treasuries, U.S. agencies, MBS and CMBS, but is more liquid than many other impact security types. Taxable municipals also require specialized research. Consequently, the yields of impact taxable municipals are competitive with investment-grade corporate yields.

Some institutional investors have implemented all of the changes discussed above to create all-impact U.S. fixed-income portfolios. Others might be more comfortable implementing changes in a more limited way. The changes merit consideration for their potential to help investors pursue their investment objectives and their values.

Scott Kirby is a vice president, senior portfolio manager and a member of the government and mortgage research team in the fixed-income group of RBC Global Asset Management, in Minneapolis.