Article 8 Transition Having Muted Impact on Bond Funds

Complex assessment needed to understand how ESG is embedded into investment processes of bond funds, says Morningstar.

Many European bond funds have focused on maintaining consistent risk/return profiles when adapting to Article 8 status under the Sustainable Financial Disclosure Regulation (SFDR), according to a new analysis from Morningstar, rather than targeting investment in bonds with strong green credentials.

In its examination of the impact of the Article 8 designation on European-domiciled fixed income strategies, the data and analysis provider said portfolio changes had been “relatively subdued”.

“Managers have been looking to replicate the risk/return profile of bond issues that have been excluded – whether that includes cyclical names or ones with a defensive profile – by replacing them with securities that have exhibited a similar upside/downside behaviour,” the report said.

Morningstar said transition to Article 8 had required most funds to exit just 2-5% of their portfolios, typically due to value-based or norms-based exclusions. As such most fund managers have not found Article 8 status to constrain flexibility regarding investment process or sources of alpha.

The data provider said managers were at different stages in their ESG integration efforts, with ESG factors often fully embedded in fundamental bottom-up analysis, supported by internal and external data sources, and engagement processes with issuers.

It highlighted the JPMorgan Global Corporate Bond fund, rated neutral, as one example of a manager adjusting allocation parameters to “counterbalance” the impact of exclusions, by increasing its limit to high-yield bonds and contingent convertibles (CoCos).

BlueBay’s Investment Grade Bond fund was actively seeking alternative non-cyclicals to its allocation to bonds issued by tobacco firms, such as in the healthcare or beverages sector, it said.

Adapting to SFDR

According to Morningstar data published in September last year, global assets in ESG funds had tripled to US$350 billion over the last three years, though fixed income remained an underrepresented asset choice.

While it seems managers are now adapting their flagship bond funds through the development of ESG-friendly practices and process, the transition remains in its infancy.

However, the pace is expected to pick up as Article 8 funds will be required to disclose more details on their ESG credentials once SFDR’s Level 2 comes into force.

When asked about the due diligence asset owners should use to assess the green credentials of their Article 8-labelled bond funds, Evangelia Gkeka, Senior Manager Research Analyst at Morningstar, told ESG Investor: “Asset owners will need to carefully assess a number of factors. Assessing the sector exclusions is straightforward, but the assessment of how ESG is embedded into investment processes is more complicated.

“Asset owners must assess how ESG factors impact security selection, including specific examples of best-in-class companies and what drives the managers’ conviction. They must also look at examples of companies that are on a positive ESG trajectory, and examples of holdings that have been sold in portfolios due to deteriorating ESG profile.”

Gkeka explained that investors should also examine the input of dedicated ESG professionals in the investment process and how they support the selection process, as well as how portfolio managers and ESG teams collaborate and drive engagement with investee companies.

How managers will develop their method for structuring Article 8 bond funds in future, in response to reporting in line with the EU taxonomy and SDFR, remains to be seen.

Gkeka said: “We expect managers to work on sophisticated reporting (an area that is still work-in-progress from what we have seen so far) that clearly illustrates the positive impact of embedding ESG into investment process and provides comparative portfolio statistics compared to benchmarks.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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