Green Bonds

Diverse Harvest as ESG Bond Funds Catch up with Equities

ESG bond funds are growing in number and innovation as managers compete to meet demand, but investors must ensure their aims are aligned with strategies.

According to funds data and analytics provider Morningstar, global assets in ESG bond funds have tripled over the last three years to US$350 billion. Nevertheless, fixed income remains under-represented in the growing ESG space.

Fuelling demand for ESG investments is the drive towards financing companies’ net zero greenhouse gas commitments and an increased focus on sustainability on the part of asset owners and other long-term investors. Living through Covid-19 has also highlighted the importance of social investing. Until recently, these issues have primarily been addressed from an equity perspective.

“Responsible investing was originally embraced more readily by equity investors,” said Carmen Nuzzo, Head of Fixed Income at the Principles for Responsible Investment. “They have more institutionalised channels to affect corporate strategies, partly because they have voting rights, but also because they participate at annual general meetings.”

Relationships between bondholders and borrowers have traditionally been more distant, but that is changing. Fixed income investors have realised the influence they have over how bond proceeds are used, and the pressure they can apply to a company’s strategy, both in terms of minimising ESG risks and optimising opportunities.

As demand for ESG bond product has increased, so has the supply of funds, albeit from a relatively low base.

“It’s part and parcel of the product development cycle,” said Jose Garcia Zarate, Associate Director of Passive Strategies for Morningstar. “It was much easier to develop funds with ESG propositions on the equity side because there was a lot of data and historical research done on corporations. That was not so much the case on the bond side.”

Initially, appetite for sustainable investment found its supply-side response largely through product created to deliver ESG-informed exposure to the equity markets. “There’s been a bit of a lag in research for fixed income. But it’s catching up, and that’s why we’re seeing much more interest in product creation,” said Zarate.

Widening array of strategies

Product development has accelerated in the past couple of years, with the launch of 122 new ESG bond funds in 2020, and an additional 45 switching from a conventional to a sustainable mandate, according to Morningstar.

As of March 2021, the total ESG bond funds universe had reached 900, comprising both open-ended funds and ETFs that claim to have a sustainability objective for their investment selection. The numbers discount cursory exclusionary screens, such as controversial weapons, tobacco, and thermal coal. Money market funds, feeder funds, and funds of funds are likewise excluded.

Funds are constructed along many different lines and encompass active management or passive strategies. This can be seen in the latitude granted to managers of active funds to invest in ‘unlabelled’ green bonds and the range of indexes and benchmarks being developed for passive vehicles to follow. Innovation is evident across all styles, but the sustainable efficacy of some approaches is more questionable in their potential impact than others.

“There are bond funds, corporate or sovereign, that are applying ESG or sustainability criteria, but they are used for general purposes, not specific sustainable projects,” said Stephanie Maier, Global Head of Sustainable and Impact Investment at GAM. “We also have green or sustainability bond funds, which have very clear use of proceeds so that you know the money you’re investing is going towards very specific green activities and green projects.”

Straight-through proceeds

Funds referencing green, social or sustainable bonds are perhaps the most transparent vehicle for ensuring investments have a clear real-world impact as well as a financial return. Numbers of impact funds are on the rise and account for 10% of all ESG bond funds. Of these, green bond funds are the dominant flavour, which reflects the growth of these assets in the underlying bond market – issuance volumes of green bonds and social bonds have grown from around US$40 billion in 2015 to already more than US$430 billion this year to mid-August, according to Refinitiv.

As volumes of ESG bonds expand, the diversity of issuer-type to be found in the market has also widened. Initially dominated by supranational borrowers, the market now accommodates corporates, sovereigns, financial institutions and a smattering of high yield or emerging market debt. Greater diversity in the underlying market gives fund managers the opportunity to develop a broader product range with ESG as an overlay.

“Issuance of green bonds is really expanding,” said Antonio Celeste, Head of ESG ETF Product at Lyxor ETF. “In 2017, we issued an ETF investing in corporate and sovereign bonds and now we are able to issue an ETF investing only in sovereign bonds. The more the market expands, the more you will be able to segment it into targeting a specific portion of the market. The risk/return with green or social bonds is no different to conventional bonds, the only difference is that proceeds will be invested to finance a given type of specified activity.”

Scores of scores

But bonds specifying the use of proceeds are not the only way of channelling fixed income investment into promoting sustainability. Managers of bond funds rather employ taking an ESG view at the corporate level to construct portfolios, either through negative or positive screening.

Company-level ESG scores can help managers avoid debt from issuers following certain undesirable practices or, increasingly, tilt investments towards borrowers with improving sustainability strategies. Yet the use of ESG scores brings with it its own potential for complexity, even confusion.

The broad array of third-party ESG rating providers can sometimes result in different sustainability ratings being assigned to the same company. In addition, managers may also rely on proprietary ESG research to determine their choice of exposure. It is important to understand the underlying methodology employed.

“There is room for a variety of approaches to sustainability, but it absolutely needs to be clear to the end-investor what approach is being applied in assessing the underlying corporate and using those scores to either tilt or screen,” said Maier. “There needs to be transparency around how methodologies are defined.”

The need for transparency rolls up to the fund manager itself when assessing ESG credibility. And this is particularly apposite in the case of once-traditional bond funds being relabelled with green or sustainable credentials to jump on the ESG bond fund bandwagon.

“We’re seeing some existing funds that have been relabeled as sustainable by excluding a few bond issuers,” said Sarika Goel, Global Head of Sustainable Investment Research at Mercer Investments. “In order to get any level of comfort around making funds more sustainable, I think we need to see some clear changes taking place with the fund manager. If all you’re doing is taking out a few things but not really changing anything else, it wouldn’t convince me. We’d need to see some changes to the investment philosophy and the process. Otherwise, this is where there’s a greater chance of there being greenwashing.”

From voluntary to mandatory

At a time when sustainable investing is subject to a mix of voluntary and mandatory frameworks, green bonds and the funds that invest in them play an interesting role in the journey toward greater transparency, accountability and impact.

Michael Hünseler, Head of Active Fixed Income at Munich ERGO AssetManagement GmbH (MEAG), sees green bonds as “a helpful shortcut” for sustainability-oriented investors looking for transparency on how their investment is being used by the issuer.

But the final goal is for investors to have full transparency from corporate issuers about their ESG performance across all their activities. This is also the aim of the EU Taxonomy, he notes, and other aspects of the sustainability disclosure regime being put in place by the European Commission.

ESG bond funds can be found in both the ‘light green’ Article 8 category under the Sustainable Finance Disclosure Regulation (SFDR) and the darker green Article 9 category in which sustainability is an explicit objective, requiring high levels of oversight for managers and tough targets for issuers.

Engagement is taking bondholders’ ESG ambitions to the next step, according to Hünseler. “Many SFDR Article 8 funds use exclusion criteria, but exclusion can take a very long time to improve the ESG performance of a firm, for example by increasing its refinancing costs and decreasing its competitiveness.”

Engagement also helps companies to better understand the specific needs and investment criteria of bondholders, while also improving the overall ESG situation. Munich Re is one of the many institutional investors to have joined Climate Action 100+ to increase the pressure from investors on companies to make their business model more sustainable.

“Companies are already walking down this road. Some may not be evaluated from an ESG perspective initially, but they are improving over time,” he said.

Clearing the air

It seems clear that ESG bond funds will continue to grow in popularity as part of the overall approach to investing in fixed income and sustainability.

“People have realised bondholders have a very important role to play because they can really decide where to channel capital to which project, and also how to support companies in the transition to more sustainable business models,” said Nuzzo at the Principles for Responsible Investment.

Transparency, regulation and the consequent credibility of ESG bond funds will determine the market’s rate of growth. But investors will still need to do their homework to better understand what they are financing.

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