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Fixed income - making ground in ESG

Demand for ESG Fixed Income exposure is soaring, with ETFs seeing a surge in AuM.

For years, fixed income trailed equities in environmental, social and governance (ESG) investing. But things are changing fast; of the €16.1bn that’s flowed into Europe-domiciled fixed income ETFs over 2022-to-date, ESG funds collected €13.6bn, attracting 84% of bond fund inflows1.

Demand for ESG bonds is rising significantly. And so is the choice of efficient passive ESG fixed income solutions. As investors appreciate the benefits of incorporating ESG in fixed income, this rapidly growing market segment offers wide-ranging investment opportunities.

ESG in Fixed Income: delayed start, but catching up fast

The first equity ESG index launched in 1990, yet the first ESG bond index didn’t appear until 2013. Since then, compared to equities, progress to integrate ESG considerations into bond portfolios has been slow, partly due to engagement factors. Bondholders lack the voting rights of shareholders, fostering the myth that they have limited ability to engage with and exert influence on companies. Of course, success in bond investing is more defined by avoiding losers than picking winners – integrating ESG considerations into bond portfolios can help with this challenge, reducing risk and potentially improving returns. And companies that regularly raise funds through bond issuance increasingly recognise the benefits of listening to bondholders.

As more investors have recognised the virtuous circle, demand for ESG fixed income solutions has grown.  Between end of 2019 and end of September 2022 AUM in European Fixed Income ESG ETFs soared from €20.1 billion to €55.2 billion1.

Making major inroads

Incorporating ESG analysis in fixed income investing brings several potential benefits. ESG scrutiny of a bond issuer may reveal exposure to long-term investment risks, such as climate change, that may take years to materialise. Additionally, several studies2 have suggested that companies with strong ESG credentials are less likely to default, and more likely to be profitable over the long term.

Hence, asset managers have been working hard to develop solutions that integrate ESG into fixed income. ESG factors are playing a more important role in credit ratings, and bond investors are increasingly engaging directly with companies, holding them to account on ESG issues. Bondholders recognise that lacking the voting rights of equity investors in no way lessens their right as stakeholders to engage with issuers (who are often also stock issuers). Keen to attract ESG investors and gain inclusion to major ESG indices, bond issuers are now much more forthcoming with information.

Another helpful factor is the improved availability of data from ESG information providers in previously neglected areas, such as government bonds. For a host of reasons, such as the lack of consistency in measuring material ESG factors, and less well-developed ESG tools/practices, government debt lags far behind credit in ESG integration terms.  However, greater investor scrutiny of ESG issues has been driving progress in this area.

So advancement on greater ESG integration in fixed income has gathered newfound momentum - alongside greater investor adoption of fixed income ESG ETFs.