As demand for ESG bonds has soared, so has the choice of efficient passive ESG fixed income solutions.
ESG in Fixed Income: delayed start, but catching up fast
The first bond ESG index was launched in 2013, a full 23 years after its ESG equity index equivalent. Since then, compared to equities, progress to integrate ESG considerations into bond portfolios has been slow, partly due to engagement factors. Bondholders lack shareholders’ voting rights, fostering the myth that they have limited ability to exert influence on companies. Of course, while successful bond investing can be defined by avoiding losers than picking winners – integrating ESG considerations into bond portfolios can help with reducing risk and potentially improving returns. Furthermore, 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 €20.1bn to €55.2bn#.
Making major inroads
Incorporating ESG analysis in fixed income investing brings several potential benefits. ESG scrutiny of bond issuers may reveal exposure to long-term investment risks, such as climate change, that may take years to materialise. Additionally, several studies have suggested that companies with strong ESG credentials are less likely to default, and more likely to be profitable over the long term.
ESG factors are playing a more important role in credit ratings, and bond investors are increasingly engaging directly with companies, holding them accountable on ESG issues. Bondholders recognise that lacking the voting rights of shareholders 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 indices, bond issuers are increasingly forthcoming with information.
The availability of data from ESG information providers in previously neglected areas, such as government bonds, has also improved. For several reasons, including the lack of consistency in measuring material ESG factors, government debt lags far behind credit in ESG integration terms, although greater investor scrutiny of ESG issues is helping to narrow the gap.
ESG: mainstream in 2022
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 and the Bank for International Settlements, recognised their versatility, even highlighting ETFs’ role in price discovery, particularly in fixed income. Covid-19 also sharpened investor focus on ESG, illustrated by in-flows of €18.1bn in European fixed income ESG ETFs over the last 12 months*.
The attraction of fixed income ESG ETFs:
- Cost-efficiency – helps make sustainable fixed income solutions accessible to all 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 ahead
In our view, rising investor appetite for fixed income ESG ETFs will continue to drive product innovation and choice for investors. 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 instruments 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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*Source: Amundi ETF / Bloomberg, end September 2022
#For example, ISS ESG in 2020 (https://www.pionline.com/esg/iss-study-links-esg-performance-profitability); McKinsey in 2019 (https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx)
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