Environmental, social and governance (ESG) principles have not traditionally been popular with fixed income investors, especially in the ETF space. Having originated in the active equities space, ESG investing has remained focused on equities for some time, however, over the last few years, the interest in ESG from fixed income investors has grown, and so has demand for fixed income ESG passive products and indices.
A recent survey by Tabula Investment Management found that 82% of professional investors want to see more innovation within fixed income ESG ETFs, while the Index Industry Association has revealed that the number of fixed income ESG indices available globally is on the rise, accounting for much of the 40% rise in the overall number of ESG indices over the past year.
However, fixed income still makes up a small proportion of overall passive sustainable assets both globally and even in Europe, where the sustainable passive space is far better developed than elsewhere.
According to Morningstar’s Global Passive ESG Landscape 2020, just 9% of sustainable index assets sit in fixed income funds globally, compared with 22% of their non-sustainable market peers, with the data providers saying the passive sustainable fixed income space “remains at an embryonic stage, particularly outside of Europe”.
Yet the demand is clearly there, evident from the increasing flows into fixed income ESG ETFs over the past five years. TrackInsight data shows global AUM in these products have increased from just $1.4bn to $14.9bn since 2014.
And when the demand is there, launches tend to follow. In Europe, 27 new fixed income ESG ETFs have been launched this year as of 19 October, according to TrackInsight. This makes up around a third of all fixed income ETF launches in 2020 and nearly half of the total number of fixed income ESG ETFs available in Europe, which stands at 66.
The engagement challenge
However, issues remain. One of the biggest criticisms of ESG investing through passives has always been the problem of engagement, with opponents saying passive funds are unable to exercise voting rights and have individual conversations with companies the way active managers do.
For fixed income investors, this engagement element is harder still as Carmen Nuzzo, head of fixed income at the Principles for Responsible Investing (PRI), said: “It is harder for bond holders to engage than it is for shareholders as they don’t have institutionalised channels or voting rights.”
However, there is still much bond investors can do to engage, from speaking directly to companies to using more collaborative initiatives, she said, adding that “by influencing how the indices are constructed, they can engage on systemic issues”.
The latter is one of the key challenges when it comes to ESG ETFs more generally, she added, which is not helped by the ever-growing number of index providers and the lack of uniformity when it comes to the ESG scores used by each.
“Screening or re-weighting companies based on ESG scores can introduce sectors of geography skew or biases with unintended implications for the risk/return profiles,” she explained.
“In addition, the methodology of ESG data providers is not always very transparent. Investors need to do more work to get index providers to be more transparent on how they produce the data and scores.”
This does not mean it is not possible for investors to achieve their sustainability goals in fixed income through ETFs, however, Vasiliki Pachatouridi, head of EMEA iShares fixed income strategy at BlackRock, said.
“Our research suggests it is feasible to create portfolios that offer a significant uplift in key sustainability metrics – including ESG scores and measures of carbon intensity – while adhering closely to key characteristics of standard bond indices, such as their duration and yield,” she said.
“The history of these indices is relatively short. But the early evidence suggests it is possible for investors to adopt them without sacrificing their risk/return objectives.”
In fact, she noted that sustainable fixed income ETFs have a similar return profile against parent indices, despite removing between 30-50% of the market cap of the index, since “fixed income indices have less idiosyncratic risk than equivalent equities indices”.
Meanwhile, ESG information providers are improving their offering for fixed income investing, expanding from corporate into private companies and even sovereign debt, which has until now been particularly underrepresented.
The latter, however, has been a sticking point in the developments for some time. According to Morningstar, “while corporate bonds can be scored using a similar ESG scoring system to equities, there are still question marks over how to best evaluate government debt, where there is a fine line between making an objective ESG assessment and straying into political territory”.
Specifically, Morningstar noted it can be particularly difficult to implement an ESG view when it comes to investing in developed market sovereign debt, such as US treasuries.
“Some ESG-conscious investors may consider some of the policies of the current US administration – like the withdrawal from the Paris Climate Agreement – to go against the most basic of ESG principles,” the data provider continued. “One must seriously consider, though, the implications of excluding the largest developed government bond market in the world from a bond fund.”
However, Brett Olson, head of iShares fixed income, EMEA, at BlackRock, said the lack of government bond ESG solutions available to investors has meant many have overlooked the impact of climate change on their portfolios.
“To date, investors have considered climate risk from an equity or corporate debt perspective, despite the average allocation to government bonds in client portfolios being around 17%,” he said.
BlackRock has sought to plug this gap with the launch of its first ESG government bond ETF in October, the iShares € Govt Bond Climate UCITS ETF (SECD), which tracks the FTSE Advanced Climate Risk-Adjusted European Monetary Union (EMU) Government Bond index. SECD includes an assessment of the expected economic impact on European nations of transitioning to a two-degree pathway by 2050.
Olson said: “While consensus on social and governance issues relating to sovereign issuers may be more complicated due to their political nature, the obligations of the Paris Climate Accord for sovereign issuers to report and publish current state and future plans of alignment with a two-degree pathway has meant increased transparency and materiality has emerged on climate risk.”
Meanwhile, another area where sustainable product choice is still lacking is emerging market debt ETFs, with just one fixed income ESG ETF launched so far this year investing in emerging markets and none allocating to China specifically, according to TrackInsight.
Anaëlle Ubaldino, head of quant advisory at Koris International, attributed this to the difficult access to data in the region, adding “providers of indices cannot efficiently create a fixed income ESG index of Chinese bonds if they don’t have the ESG metrics at a company level”.
However, she noted that China had pledged to make the nearly 4,000 corporates listed in the country publish ESG metrics by the end of the year, which, if successful, could significantly improve data availability and in turn drive product development.
“[China is] aware that flows are going to ESG investments and they want to remain appealing [to fund buyers],” she continued. “We are definitely going to see some development in this area as soon as product providers have the underlying data to start developing products.”