Sustainable fixed income investing is growing at a rapid rate as investors increasingly seek to improve their portfolio environmental, social and governance (ESG) characteristics to address climate risks, meet new regulations, and adapt to new investment preferences.
The majority of investors who are choosing indexed exposures to build their sustainable portfolios are currently following Socially Responsible Investing (SRI) indices, with 93% of sustainable indexed fixed income UCITS exchange-traded fund (ETF) AUM tracking these type of indices.1
Achieving portfolio outcomes while improving sustainability profile
Market conditions can amplify differences in risk and returns between SRI indices and their parent non sustainable indices. With an understanding of these dynamics and having the right analytical tools will be important to investors who seek to improve their fixed income sustainability profile while achieving desired portfolios outcomes, such as targeting a set yield level or duration profile.
Implementation with indexing
In particular, the proliferation of index-tracking sustainable fixed income ETFs is giving investors rules-based methodologies that provide transparency, accessibility, liquidity and efficiency.
Sustainable investing has been around for years in equity markets, but the practice is a more recent addition to the fixed income landscape. Index-tracking sustainable fixed income ETFs have particular appeal: they are low-cost and liquid, and they track indices which provide visibility into which bonds are eligible based on criteria such as ESG ratings, exposure to controversialactivities and carbon intensity. In a short period of time, responsible investing has become a popular practice in the fixed income universe, as evidenced by the phenomenal growth the asset class has undergone.
Statistics show the number of global assets invested in sustainable fixed income ETFs has dramatically expanded from year to year. In fact, in the seven years from January 2015 to December 2021, investment in these more sustainable instruments increased by 3,682% (from $1.4bn in January 2015 to $50bn in December 2021). This compares with an increase of 403% in traditional fixed income ETFs (from $436bn in January 2015 to $1.8trn in December 2021).2
Understanding drivers of risk and return in sustainable bond portfolios
ETFs and index funds offer several benefits when it comes to integrating sustainability in fixed income allocations. These funds track indices that are built utilising a rules-based approach, giving investors clear visibility into the sustainable criteria for bond inclusion from independent specialist data providers. Sustainable fixed income ETFs and index funds can be cost-effective and transparent, offering a daily look at a fund’s ESG composition and characteristics.
These features make sustainable fixed income ETFs and index funds effective tools for incorporating sustainable considerations in a consistent way across the whole portfolio. We believe this is a process which starts with a clear understanding of the existing characteristics of your bond portfolio and the subsequent risk and return implications associated with the switch to sustainable alternatives. A sustainable fixed income portfolio’s risk and return is determined by the same drivers that impact a typical, non-sustainable portfolio, such as duration and credit quality.
Understanding these drivers of risk and return is key to building a sustainable fixed income portfolio that meets an investor’s goals. Our research suggests that when analysed over the longer period, a sustainable fixed income portfolio has been shown to exhibit improved overall portfolio resiliency, sustainable profile improvements, and potentially lower overall portfolio risk.3 Investors can manage the differing risk characteristics at an asset allocation level by making some adjustments to ensure their portfolio remains aligned with their desired investment outcomes, along with their sustainability goals.
Incorporating sustainability: resilience and impact
An essential step in achieving desired portfolio outcomes is developing an understanding of sustainable fixed income index characteristics – and importantly, what is driving returns. While it might stand to reason that explicit sustainable characteristics drive returns, BlackRock analysis demonstrates that sustainable fixed income index returns are driven by the same risk and return variables as their traditional counterparts. In other words, risk and return drivers such as credit quality and duration drive returns in sustainable fixed income indices just as they do for their parent indices.
Despite the same characteristics driving returns, there may be considerable return differences between sustainable fixed income indices and their parent indices. It is important to recognise that it is not sustainable characteristics driving these differences – rather, it is differentiation in the fixed income characteristics themselves. BlackRock’s research has evidenced that the impact of sustainable characteristics on bond prices remains small, with a lack of stable relationship over time and no significant price differential for higher ESG rated issuers.4 BlackRock continues to monitor this dynamic and its impact on performance differentials between sustainable and non-sustainable indices.
Sustainable fixed income indices differentiated returns may be attributed to these distinctfixed income risk and return drivers. In the example on tables 1 and 2, the Bloomberg MSCI US Corporate Sustainable SRI Index exhibits lower duration and yield-to-maturity than its non-sustainable counterparts (Bloomberg US Aggregate Corporate Bond Index and Markit iBoxx USD Liquid Investment Grade index), however, these drivers of return may vary across time periods. In general, the extent to which a particular fixed income risk and return component explains re-turns is market regime-dependent. For example, during periods of rising interest rates, duration is a larger driver of returns. During risk-on or risk off periods, credit rating primarily explains returns and the greater resiliency investors achieve in risk off markets when holding sustainable exposures.
Deliberate focus on the risk and return drivers in a sustainable fixed income portfolio enable greater control and help avoid unintended outcomes.
Implementing sustainability in fixed income portfolios
Integrating sustainability in fixed income allocations does not mean departing from risk and return objectives. We believe it is possible to build fixed income portfolios with significantly improved sustainability metrics while closely adhering to key characteristics of standard bond indices. Achieving desired portfolio outcomes while incorporating sustainability starts with understanding the risk and return characteristics of sustainable indices – and also knowing the characteristics of your bond portfolio.
How investors approach sustainable
While there are several approaches to integrating sustainability across fixed income allocations, 93% of sustainable indexed fixed income UCITS ETF AUM tracks sustainable SRI indices,5 based on business involvement and minimum ESG ratings.
An indexing approach to sustainable fixed income may come with several benefits. Sustainable fixed income indices are built with a rules-based transparent approach, where investors have clear visibility into constituents and the reasons behind additions and deletions. This gives sustainable fixed income index fund investors transparency into the impact of their investments – and enables them to target portfolio outcomes with precision. Sustainable fixed income indices are constructed with a three-pronged approach:
BUSINESS EXCLUSION CRITERIA: Baseline screens that eliminate issuers that pose certain risks or violate an investor’s values.
ESG RATING: Three key areas of environmental, social, and governance used to measure sustainability and ethical impacts of an investment in a company.
ESG CONTROVERSIES: Removal of issuers linked to events or headlines that pose risks, eliminate issuers that pose certain risks or are engaged in certain business activities that violate the funds’ investment objectives.
Knowing your beta
When building sustainable portfolios, it is important for investors to be aware that each fixed income asset class comes with its own unique characteristics. For example, EUR investment grade corporate bonds are highly homogenous in their credit quality, sector, and maturity, while USD investment grade bonds offer more disparate characteristics.
While emerging market bond returns tend to be driven by idiosyncratic risk, variables such as interest rates may have the most impact on developed market bond returns.
As each fixed income asset class has its own unique features, sustainable characteristics may impact performance in different ways. This is why incorporating sustainability in fixed income requires investors to know their beta at an asset class level.
Implementation with index funds may have several benefits
Integrating sustainability while maintaining fixed income risk and return objectives requires a comprehensive understanding of both sustainable fixed income and existing fixed income portfolio characteristics. With this knowledge, investors can integrate sustainability with whatever adjustments are deemed necessary at the asset allocation level to maintain the portfolio’s risk and return profile.
Sustainable fixed income index funds are ideally suited for this purpose for several reasons. Sustainable fixed income indices are built with an objective, rules-based approach, and the index funds that track them generally publish their holdings daily. As such, sustainable fixed income index funds offer transparency in their composition and characteristics – giving investors the detail they need to integrate sustainability while targeting desired outcomes with precision.
Sustainable fixed income indices have also been shown to deliver on their objective of improving sustainable profiles, both with respect to ESG rating and carbon emissions intensity. An ESG rating is a measure of an issuer’s resilience to long-term, industry material environmental, social, and governance risk. When an index is constructed, its ESG rating may improve by removing the lowest rated ESG issuers from the starting universe of bonds. Carbon emissions intensity measures how much a company is emitting relative to its level of business output.
This metric may improve with fossil fuel-related business involvement screens and translation of higher emitters (relative to output) to a lower environment rating (industry specific) as part of the overall issuer ESG rating. As shown in Figure 9, for US investment grade corporate bonds, the sustainable index delivered significant sustainable profile improvement by both metrics.
Investors utilising ESG ratings and carbon emissions intensity metrics at an overall portfolio level should understand drivers of improvements in both metrics. For example, in Bloomberg MSCI US Corporate Sustainable SRI Index the ESG rating improvement is achieved through both business involvement screens and removing issuers with below BBB ESG rating from MSCI.
How to implement sustainability into fixed income portfolios
Incorporating exposures with an enhanced ESG rating into existing fixed income portfolios will improve the overall resiliency of that portfolio and potentially lower overall portfolio risk. For investors who wish to demonstrate a commitment to a specific objective such as carbon intensity reduction, sustainable SRI fixed income index exposures provide an immediate, scalable solution.
By incorporating sustainable SRI fixed income exposures into conventional fixed income portfolios, investors may potentially improve traditional investment risk metrics while also achieving specific ESG objectives.
But how can ETFs help investors achieve their sustainable goals?
They have proven resiliency
Sustainable fixed income ETFs rated higher than their conventional peers on the ability to be resilient amid a challenging market environment. Evidence shows that sustainable fixed income indices have retained a better bounceback during “risk-off” periods (challenging economic times during which investors seek to reduce risk). During the risk-off period brought on by the onset of the Covid-19 pandemic in February and March 2020, sustainable indexes outperformed across a number of fixed income asset classes, including emerging markets, US investment grade, and US high yield.6
They have an improved sustainability profile
Fixed income ETFs allow investors to incorporate sustainability into their existing portfolios or build new portfolios with specific sustainable objectives. For example, investors can replace their investment-grade bond fund with a sustainable option. This one adjustment could have a notable effect on an investors’ overall portfolio’s ESG score. Say, for example, an investor is invested in an investment-grade bond with a relatively high carbon-intensity score of 310. Switching this holding for a sustainable equivalent with a carbon-intensity score of 95 could raise a fund’s overall ESG score by circa 10%.7 The sustainable option has a much lower carbon emissions intensity, and a higher/improved ESG score.
They are cost-effective
At the individual investment level, ETFs can lend affordable and efficient access to sustainable fixed income markets. They allow market participants to increasingly incorporate sustainable aspects into their investments, providing portfolio resilience. They are transparent, accessible, liquid and efficient, making these instruments increasingly useful tools for improving the sustainability profile of fixed income portfolios.
Conclusion
Now, more than ever investors are choosing to build their portfolios with sustainable fixed in come and are largely following an indexed bestin-class approach. Our research suggests that integrating sustainability through best-in-class (sustainable SRI) indices can impact the risk and returns of certain fixed income asset classes more than others.
At the same time, different market conditions can amplify differences in risk and returns between sustainable SRI indices and their parent non-sustainable indices. With an understanding of these dynamics and having the right analytical tools will be important to investors who seek to improve their fixed income sustainability profile while still achieving the desired portfolios outcomes, such as targeting a specific yield level or maintaining a desired duration profile.
To learn more about BlackRock’s index solutions for UK pension schemes, please contact Henry Odogwu, Head of UK iShares Institutional Sales – Henry.Odogwu@blackrock.com and visit our website at https://www.blackrock.com/uk/professionals/solutions/index-investing and to learn more about sustainable fixed income ETFs, search “iShares sustainable fixed income”.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
1 Source: BlackRock, 31/12/20212 Source: BlackRock and Morningstar as of 31/12/2021. This statement is based on the results of stress tests effectuated by Risk and Quantitative analysis team on different hypothetical marketscenarios - comparing the performance of the ESG index to its Parent index. The sample tested included USD IG ESG represented by the index Bloomberg MSCI US Corporate Sustainable SRIIndex, USD IG Parent represented by the index Bloomberg US Corporate Index, EUR IG ESG represented by the index Bloomberg MSCI Euro Corporate Sustainable SRI Index, EUR IG parentrepresented by the index Bloomberg Euro Corporate Index, USD HY ESG represented by the index Bloomberg MSCI US Corporate High Yield Sustainable BB+ SRI Index, USD HY Parent represented by the index Bloomberg US High Yield Index, EUR HY ESG represented by the index Bloomberg MSCI Euro Corporate High Yield Sustainable BB+ SRI Index, EUR HY Parent represented by the index Bloomberg Euro High Yield Index, EM ESG represented by the index JP Morgan ESG EMBI Global Diversified, EM Parent represented by the index JP Morgan EMBI Global Diversified3 Source: BlackRock, 31/12/20214 Source: BlackRock, 31/12/20215 Source: BlackRock GBI, as at 31/12/2021.6 Source: BlackRock and Morningstar as of 31/12/2021. This statement is based on the results of stress tests effectuated by Risk and Quantitative analysis team on different hypothetical market scenarios - comparing the performance of the ESG index to its Parent index. The sample tested included USD IG ESG represented by the index Bloomberg MSCI US Corporate Sustainable SRI Index, USD IG Parent represented by the index Bloomberg US Corporate Index, EUR IG ESG represented by the index Bloomberg MSCI Euro Corporate Sustainable SRI Index, EUR IG parent represented by the index Bloomberg Euro Corporate Index, USD HY ESG represented by the index Bloomberg MSCI US Corporate High Yield Sustainable BB+ SRI Index, USD HY Parent represented by the index Bloomberg US High Yield Index, EUR HY ESG represented by the index Bloomberg MSCI Euro Corporate High Yield Sustainable BB+ SRI Index, EUR HY Parent represented by the index Bloomberg Euro High Yield Index, EM ESG represented by the index JP Morgan ESG EMBI Global Diversified, EM Parent represented by the index JP Morgan EMBI Global Diversified.
Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This is for illustrative and informational purposes and is subject to change. It has not been approved by any regulatory authority or securities regulator. The ESG considerations discussed herein may affect an investment team’s decision to invest in certain companies or industries from time to time. Results may differ from portfolios that do not apply similar ESG considerations to their investment process.
The benchmark index only excludes companies engaging in certain activities inconsistent with ESG criteria if such activities exceed the thresholds determined by the index provider. Investorsshould therefore make a personal ethical assessment of the benchmark index’s ESG screening prior to investing in the Fund. Such ESG screening may adversely affect the value of the Fund’sinvestments compared to a fund without such screening.This document is marketing material: Before investing, please read the Prospectus and the KIID available on www.ishares.com/it, which contain a summary of investors’ rights.
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