Fixed Income: Making ground in ESG

FIXED INCOME 05 September 20225 MIN READ

Fixed income has long lagged equity in the environmental, social and governance (ESG) investing space, accounting for almost 19% of sustainable assets globally¹. But at the end of 2020, this figure was closer to 9%. Demand for ESG debt is rising significantly, as is the choice of efficient passive ESG fixed income solutions. As investors learn the benefits of incorporating ESG in fixed income, this rapidly growing segment of the market presents significant investment opportunities.

A slow start, but…

Progress to integrate ESG considerations in fixed income portfolios has been slow, compared to equities. The first equity ESG index was launched in 1990, but it was not until 2013 that the first ESG fixed income index materialised.

One reason for this relates to engagement. Bondholders do not have the voting rights of shareholders, leading to a myth that they have a limited ability to engage with and exert influence on companies. Yet for bond investors, success is defined less by picking winners than by avoiding losers. Integrating ESG considerations into a bond portfolio can help with this challenge, reducing risk and potentially improving returns. Issuing companies that regularly raise funds in bond markets increasingly see the benefits of listening to bondholders, creating a virtuous circle.

As investors have come to understand this point, demand for ESG fixed income solutions has grown. Between end of 2019 and end of August 2022 AUM in European FI ESG ETFs soared from €20.1 billion to €56.1 billion. So what has brought about this change and what opportunities does this bring?

Making ground

There are several potential benefits to incorporating ESG analysis in fixed income investing. ESG scrutiny on a bond issuer may reveal exposure to long-term investment risks such as climate change that may take years to materialise. It’s increasingly also recognised that companies with strong ESG credentials are less likely to default, and more likely to be profitable over the long term, according to several studies².

In light of this, asset managers have been working hard to develop solutions that integrate ESG into fixed income. ESG factors are occupying a more important role in credit ratings, and bond investors, such as asset managers, are showing a greater willingness to directly communicate with companies and hold them to account on ESG issues. They recognise that while they may not have voting rights like equity holders, this in no way lessens their right, as stakeholders, to engage with bond issuers who are in many cases also stock issuers. Bond issuers, keen to attract increasingly ESG-conscious investors and be included in major ESG indices, are now also far more forthcoming in supplying information.

There is also more data available from ESG information providers in previously neglected areas such as government debt. Government debt is far less advanced than corporate debt in terms of ESG integration, for a host of reasons including a lack of consistency with regards to measuring material ESG factors, limits to data availability, and less well-developed ESG integration tools and practices. However, increased investor scrutiny on ESG issues has been driving progress in this area.

Lately, this trend towards greater ESG integration in fixed income has gathered newfound momentum – and it has been accompanied by a greater investor adoption of fixed income ESG ETFs.

In 2022, ESG is a mainstream concern

The events of recent years have brought ESG considerations to the forefront of investors’ minds. Covid-19 precipitated market turmoil and tested portfolio resilience, leading many investors to re-evaluate their allocations to fixed income. ETFs thrived amid the volatility, proving themselves to be nimble and resilient. Large volumes of fixed income ETFs were traded, even in segments with dwindling liquidity.
Monetary authorities — including the Bank of England, the Bank for International Settlements and the Federal Reserve — recognised their versatility and even highlighted the role of ETF prices as a means of price discovery, again, particularly in the fixed income space.

The pandemic also sharpened investor focus on ESG, illustrated by significant in-flows of €18.3bn in European Fixed Income ESG ETFs over the 12 months³.

ETFs embraced as the vehicle of choice

The attraction of fixed income ESG ETFs is clear:

They are low cost, helping to make sustainable fixed income solutions accessible to all type of investors.
They offer transparency – investors can see what is in the portfolio by looking at the constituents of the underlying index.
They provide diversification and resilience – risk can be spread across hundreds, even thousands of stocks.
They are highly liquid, even in times of market stress.
They offer a high correlation with their parent (non-ESG) universe and minimal tracking error.

The increasing investor appetite for fixed income ESG ETFs will continue to drive greater product innovation and choice for investors.

There’s a long road ahead, but…

ESG progress in the fixed income market has a lot of room to run. There’s still a lack of consistency in the level of ESG information provided by bond issuers, particularly within the sovereign debt space, which can make ESG due diligence challenging. Fixed income assets still only account for a small proportion of sustainable assets globally, but there are great opportunities for growth.

ETFs are increasingly being embraced as the vehicle of choice to implement ESG fixed income in investment portfolios and we expect continued innovation and assets under management in these dynamic tools to surge.

Ultimately this should lead to greater choice for investors and an enhanced ability to incorporate sustainability in their investment portfolios in a way that reflects their investment beliefs and objectives.

1. Source: Morningstar 31/07/2022
2. For example, ISS ESG in 2020 ; McKinsey in 2019
3. Source: Amundi ETF / Bloomberg. Data from August 2021 to August 2022.

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