Why investors have not been buying ESG fixed income funds, as yet?

According to Morningstar, inflows into European-domiciled ESG funds (and ETFs) have been more substantial since the beginning of the year on the back of COVID. We would however make two observations. Firstly, the strong inflows are primarily driven by ESG equity strategies. In fact, inflows into ESG equity vehicles were three times higher than those into fixed income vehicles. Secondly, as a % of total funds’ assets under management, this allocation into ESG funds is still small, especially in fixed income. This is despite the vast underlying universe that fixed income ESG managers can tap into (see below discussion on labelled/unlabelled bonds).

So, why is it that investors have not embraced fixed income ESG funds so far? Is it because returns are lower than for traditional strategies? Or because fund buyers don’t have a specific ESG allocation? Or maybe because of the fear of greenwashing?

In this article, we would like to discuss that ESG or sustainability-focused fixed income strategies:

1. Can generate at least returns similar to traditional, non-sustainability focused strategies.
2. Can be part of a traditional fixed income allocation.
3. Need to be managed by mission-driven asset managers to reduce the risk of greenwashing.

1. ESG/Sustainable fixed income does not mean lower returns

Against the common wisdom that one has to “pay” or “accept a lower return” to invest in fixed income ESG, this is not what the data is telling us, so far. One prominent place to look at for testing that hypothesis is the green bond market. Although there is currently a debate out there on the cost of ESG, our analysis, as well as several recent academic studies, show that in fact, with very few exceptions, this does not seem to be the case for bonds. We don’t see a “greenium” as the yield of green bonds is similar to those bonds with the same characteristics from the same issuer. Therefore, investors in green bonds are getting the market yield/return commensurate to the priced risk-profile of issuers.

2. The ESG/sustainable fixed income market is big enough to be managed against traditional conventional benchmarks

Given the nature of green bonds, i.e., a special feature to conventional bonds issued by sovereigns, agencies, corporates and others, bulking them into one index might not be helpful to understand clearly the risk-return characteristics of the universe (see breakdown comparison of the green bond index below). Also, with a size of c. EUR550BN, the index is prone to significant changes in characteristics depending on the issuance patterns. For example, the issuance of a 30-year benchmark green bond for some of the AAA countries would have a meaningful impact on the overall duration of the index.

It is therefore difficult to position the index in a traditional asset allocation without the risk of incurring large tracking-error.

The unlabelled bond market

Based on data from the Climate Bond Initiative there is up to $1.5 TR in value (circa 3x the market value of the green bond universe or circa 1.3x the US High Yield bond market) of climate-aligned bonds available to be tapped into if one wants to consider, for example, all companies providing environmental solutions. The unlabelled bonds are conventional bonds issued by companies that offer solutions to social or environmental issues or other themes one would like to focus on (for ex. specific to some of the SDGs). A typical example often mentioned would be bonds issued by Vestas, the wind turbine solution company, a key component to the construction of wind farms. Assuming that the investment theme is to invest in companies that provide environmental solutions, Vestas’ conventional bonds would typically qualify as a member of the investment universe.

By tapping into both the labelled and unlabelled universes, one can construct portfolios that can have similar characteristics to the main traditional universes (for ex. the Euro aggregate market index). This is accomplished by matching the main key risk factors (yield/duration/spread) while channelling funds to companies and projects that would qualify as sustainable. We believe the size and scope of the fixed income market do offer smart investors sufficient opportunities to deliver at least broad market returns while meeting clients’ ESG preferences.

3. Pick mission-driven asset management firms to reduce the risk of greenwashing

What is ESG? What is responsible, and what is not? Well literally everyone can have his/her own definition. This is reflected by the large divergence between ESG rating providers. In a recent study from the CFA Institute Foundation , its author, Pedro Matos writes that “many ESG factors require subjective decisions”. So, who is right? Providing that the rating calculation is carried out with skill and integrity, we would argue that everyone can be right. Until a globally accepted taxonomy is created it will be challenging to make an objective judgement on what is a sustainable activity. So which fund to choose from?

As mentioned above, given that it is not yet possible to fully assess the sustainability character of an activity objectively, and despite internal processes for validating investments, understanding the ethics of the ultimate fund manager is critical. Can you trust him/her and his/her judgement? Also, as crucial is the structure, the vision, mission and culture of the firm he/she is working for. Does the company have an ESG mission? To minimise the risk of greenwashing, we would avoid investing in funds that belong to sponsors not committed to the ESG theme pursued by the fund. This is because it creates a misalignment between the corporate entity and the purpose of the fund strategy. Given the non-financial considerations, it is essential to find companies that walk the walk and talk the talk. Fund solutions that operate at the periphery of the primary operations of a fund management firm risk to be neglected from different perspectives (for ex. the resources needed to purchase the required ESG data to allow verification or how impact reporting is carried out).

As mentioned above, given that it is not yet possible to fully assess the sustainability character of an activity objectively, and despite internal processes for validating investments, understanding the ethics of the ultimate fund manager is critical. Can you trust him/her and his/her judgement? Also, as crucial is the structure, the vision, mission and culture of the firm he/she is working for. Does the company have an ESG mission? To minimise the risk of greenwashing, we would avoid investing in funds that belong to sponsors not committed to the ESG theme pursued by the fund. This is because it creates a misalignment between the corporate entity and the purpose of the fund strategy. Given the non-financial considerations, it is essential to find companies that walk the walk and talk the talk. Fund solutions that operate at the periphery of the primary operations of a fund management firm risk to be neglected from different perspectives (for ex. the resources needed to purchase the required ESG data to allow verification or how impact reporting is carried out).

Conclusion

The opportunity set for sustainability investing in fixed income is broad enough to accomplish both financial and non-financial objectives that clients may require. This is, achieving a competitive risk/return profile as well as making an impact (for example towards the reduction of GHG emissions). However, to achieve that dual objective, investors should focus, as a starting point, on mission-driven asset management firms.

Author: Fabrizio Palmucci, CFA. Fabrizio is an advisor and NED to asset managers and fintech start-ups. He has spent close to 20 years in fixed-income asset management in different roles for tier 1 and start-up asset management firms. He holds an executive MBA from the London Business School and graduated from the University Mons-Hainaut (Belgium).

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Why investors have not been buying ESG fixed income funds, as yet?