The supply of ESG-aligned bonds is increasingly underpinned by regulatory pressures and client demand for products targeting non-financial objectives. As the investable universe grows, so the number of funds and assets will increasingly find their way towards fixed-income ESG solutions. However, to strike the right balance between financial and non-financial returns investors should look for ESG-authentic leaders with good risk-return capabilities
- Academic studies show green bond yields are similar to bonds with same characteristics
- The universe of ESG bonds is large enough to generate good returns
- Investors would need to select genuine ESG funds to avoid greenwashing
According to Fundquisitive, a market research consultancy, European fixed-income funds have so far been laggards in relation to ESG, as client demand and the supply of solutions have been lagging other asset classes (figure 1). Asset owners have typically expressed three clear concerns:
• Need for return. While clients need returns, an ESG filter could constrain the potential for returns.
• Tracking-error risk. Most clients have benchmark returns to meet or outperform. ESG solutions might have a different and difficult-to-understand risk-return profile.
• Risk of greenwashing. ESG is sometimes seen as a fad and a marketing opportunity. Also, it is difficult to quantify impact.
This article will consider how these concerns can be mitigated to allow investors to consider ESG fixed-income funds as part of their core fixed-income allocation.
ESG fixed-income can generate compelling returns. Against the common wisdom that one has to ‘pay’ or ‘accept a lower return’ to invest in ESG fixed-income, this is not what the data suggests. One prominent place to look at to test that hypothesis is the green bond market. Although there is currently a debate on the cost of ESG, several recent academic studies show that, with few exceptions, this does not seem to be the case for bonds. There is no ‘greenium’, as the yield of green bonds is similar to those bonds with the same characteristics from the same issuer.
Also, the supply o f what could qualify as ESG bonds is increasing dramatically. Based on data from the Climate Bond Initiative, there is up to $1.5trn (€1.2trn) in value (about three times the market value of the green-bond universe or about 1.3x the US high-yield bond market) of climate-aligned bonds available to be tapped if one wants to consider, for example, all companies providing environmental solutions.
As a result, the universe is large enough for skilled managers to deliver compelling returns.
The ESG fixed-income market is today large enough to minimise tracking error. Given the nature of green bonds, that is adding 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. Also, with a size of about €550bn, the index is prone to significant changes in characteristics depending on the issuance patterns. It is, therefore, difficult to position the green bond index in a traditional asset allocation without the risk of incurring large tracking error.
However, by tapping into both the labelled (green bonds) and unlabelled universes ($1.5trn in value as per above), it is possible to construct portfolios that can have similar characteristics to the main traditional universes (for example, 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. The size and scope of the fixed-income market do offer able investors sufficient opportunities to deliver at least broad market returns while meeting clients’ ESG preferences.
Pick ESG authentic leaders, mission-driven, asset management firms to reduce the risk of greenwashing. Asset management firms’ main purpose has traditionally been to meet clients’ risk-returns objectives. ESG objectives are different, though, as they are non-financial and largely based on values. So while risk-return are quantitative measures, values are mostly subjective and qualitative. This is reflected by the large divergence between ESG rating providers.
In a recent study from the CFA Institute Foundation, its author, Pedro Matos wrote that “many ESG factors require subjective decisions”. As such, it will not be until a globally accepted taxonomy is created that an objective judgement on what is a sustainable activity can be made.
Therefore, a first step for a credible ESG assessment is to screen and understand the values transpiring through an investment solution and whether those consistently percolate across the firm and value chain. In our opinion, greenwashing arises when a firm is trying to retrofit the organisation with new values that it deems appetible from a marketing perspective. This experiment is, at best, difficult and takes us into the sphere of change in management and culture.
Mission-driven managers with ESG at their core have a significant advantage here as they are set up with ESG consideration in their DNA and are therefore more likely to be credible.
The table (figure 2) outlines the factors necessary to assess ESG authenticity.
The growing universe of ESG-aligned bond instruments and investment management solutions present both an opportunity and a challenge for asset owners. It is an opportunity to invest in solutions that can be part of their core asset allocation while targeting non-financial returns. However, to do this credibly requires them to find investment firms and solutions that combine both ESG authenticity and good risk-return capabilities.
Fabrizio Palmucci is a fixed-income consultant with 20 years of experience in fixed-income portfolio management