Industry Voice: Fixed income – making ground in ESG

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 studies[1] 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.


ESG: mainstream in 2022

Recent events have brought ESG considerations to the fore – Covid-19 triggered market turmoil and tested portfolio resilience, with many investors re-evaluating their fixed income allocations. ETFs thrived amid the volatility, proving themselves nimble and resilient. Bond ETFs traded in large volumes, even in segments with dwindling liquidity. Monetary authorities, including the Federal Reserve, Bank of England and the BIS, recognised their versatility, even highlighting ETFs’ role in price discovery, particularly in fixed income. The pandemic also sharpened investor focus on ESG, illustrated by in-flows of €18.1bn in European fixed income ESG ETFs over the last 12 months1.


ETFs: vehicle of choice

The attractions of fixed income ESG ETFs are clear:

• Cost-efficiency – helps make sustainable fixed income solutions accessible to all type of investors.

• Transparency – investors can see what the portfolio holds by looking at the constituents of the underlying index.

• Diversification- risk can be spread across hundreds, even thousands, of stocks.

• Highly liquid – even in times of market stress.

• High correlation with their parent (non-ESG) universe, and minimal tracking error.


ESG Fixed Income ETFs – further robust growth and innovation in prospect

In our view, rising investor appetite for fixed income ESG ETFs will continue to drive product innovation and choice for investors. Despite recent gains, we see great opportunities for fixed income to further grow its share of sustainable assets globally.

Investors are increasingly embracing ETFs as their vehicle of choice to implement ESG fixed income in portfolios and we expect continued innovation and AuM in these dynamic tools to surge. This should ultimately lead to greater choice for investors, enhancing their ability to incorporate sustainability in portfolios reflecting their investment beliefs and objectives.

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