ESG bond indices can defend investors' portfolios

ESG bond ETFs commanded some $7.6bn in assets in 2019 according to iShares, more than triple the amount recorded in 2018.

That sum had reached £10.3bn by the middle of 2020.

Given the important role of fixed income in portfolios, such offerings should prove useful for conscientious clients who value diversification.

The events of 2020 may have finally settled any lingering debates about whether ESG investing means sacrificing returns

Bond ESG passives also tend to come cheaper than active equivalents, while ETFs have notably high levels of transparency. Conscientious investors can often check the full list of an ETF’s holdings.

But as Morningstar noted in a recent report, bond passives with an ESG leaning remain in an embryonic phase. The authors of the report, “Passive sustainable funds: the global landscape 2020”, published in September, note that European investors had just 53 passive fixed income funds to choose from at the time of writing, with just 12 available in the US.

The good news is that ESG bond passives are rapidly taking on greater scale, with providers expanding into new subsectors.

Demand from various sources, from DIY investors to wealth managers and pension funds, should spur this on, resulting in greater innovation. But, as with any ESG approach, close attention should be paid to the underlying investment. Fixed income ESG passives also come with their own issues.

Passing the test

2020 has been a tipping point for ESG in two respects. Firstly, this year has seen an explosion in demand, placing it firmly into the mainstream. The events of 2020 may also have finally settled any lingering debates about whether ESG investing means sacrificing returns.

In the equity space, ESG funds have held up better than their mainstream peers, partly because ESG funds often have a bias to more defensive “quality” stocks.

Similarly, ESG bond indices have generally proved more defensive than their parent benchmarks, losing less when prices were falling but lagging as assets have rallied.

Importantly, ESG approaches in the bond space could help investors to both defend their portfolios and positively influence a large swathe of companies.

Vasiliki Pachatouridi, head of Emea fixed income strategy at iShares, notes: "In fixed income, ESG issues present a material credit risk for both corporate and sovereign debt.

"With debt issuance dwarfing equity issuance, bonds are an increasing source of corporate finance. Credit investors see an opportunity to exert meaningful influence over issues with ESG and disclosure practices."

Investors are likely to see ESG bond passives proliferate in the coming years. Offerings are already available in various areas, from investment grade corporate bonds to high yield and emerging markets.

ESG passives with a focus on government bonds are also emerging, though progress has been somewhat slower here. This relates to a variety of issues, including the difficulty of assessing climate change risk when it comes to different government bonds.

Passive ESG bond exposure: pros and cons

Jack Turner, an investment manager for 7IM, argues that many people are “too quick to discount the merits of passive ESG investing”, often for the same reasons some dislike passives more generally.

But there are reasons to favour a passive approach for ESG-friendly bonds. The companies looking to construct or use baskets of ESG bonds, from index providers to large asset managers, tend to have huge resources that should help them navigate this landscape.

Passive bond plays can also be cheap, transparent, and sometimes offer significant diversification through sheer number of holdings.

But they do face challenges. Generally, the investor always makes an “active” choice of index, and it can be crucial to closely assess the underlying investments when choosing ESG trackers. A fund could, ultimately, hold something that does not chime with a client’s beliefs.

 The uplift versus the non-ESG indices is much smaller than for ESG equity indices Matt Brennan, AJ Bell

Bond passives come with specific issues, too. Matt Brennan, head of passive portfolios at AJ Bell, notes that ESG equity indices such as MSCI’s SRI index range can exclude “bad” companies and take big positions in the names that score best on the relevant metrics.

But limited bond liquidity means such as an approach would not work within fixed income products. “This means the bond indices only make small tilts towards the best ESG companies,” he adds. “As such, the uplift versus the non-ESG indices is much smaller than [for] ESG equity indices.”

Bond markets have also tended to be less transparent. Specialists have previously warned that while companies with listed shares must make significant disclosures, not all bond issuers will provide the same level of information. This makes it harder to assess a bond issuer’s ESG credentials.

However, some have cited big improvements here. Ms Pachatouridi says: “Things have changed significantly. If you go to high yield and emerging market debt, the amount of reporting that has come out has increased materially. They [issuers] do care about ESG scores because they care about their corporate debt being included in major indices run by the largest investors in the world.”

Improved disclosure by bond issuers, and substantial analysis from research companies and index providers, is resulting in a clearer picture. Mr Turner notes, for example, that MSCI’s sustainability data now covers 94 per cent of the bond issuers in the Bloomberg Barclays US Credit index – up from 75 per cent in 2013.

This, and the proliferation of such products, could ultimately mean that bond passives play a larger role in an ESG-oriented portfolio. But they may require greater due diligence.

Dave Baxter is deputy personal finance editor of Investors Chronicle