While ESG principles have taken the equity investment sector by storm, these same values-driven principles are slowly seeping into the investment-grade bond world, producing many of the same positive results.
Over the last decade, investors’ desire to express their personal principles via their investment portfolios has transformed environmental, social, and governance (ESG) investing into a mainstream equity strategy. There is growing awareness that investment-grade (IG) corporate bond investors can use the same ESG metrics popular in equity portfolios. Though in its early stages, this awareness is leading to rapid growth in socially responsible bond investing.
By incorporating ESG into their decision-making process, bond investors may achieve superior risk mitigation. Importantly, ESG overlays can be implemented across an IG bond portfolio without sacrificing yield or portfolio returns. In this piece, we will cover the basics of bond market ESG investing, its growth, ways to implement ESG in a fixed income portfolio, and its impact on yield.
What is ESG investing?
ESG investing began as a simple way for investors to avoid supporting companies and industries engaged in activities that weren’t compatible with the investors’ personal beliefs. It has evolved into a sophisticated process that now involves direct engagement with management teams.
As companies have voluntarily disclosed more nonfinancial ESG information, the number of investment screens has grown, and can be customized to fit almost any individual’s personal principles. For instance, an investor can identify companies that engage in tobacco sales or production, are involved in factory farming, face child labor controversies, or have non-diverse boards. These companies can then be readily eliminated from consideration for their portfolio. Companies that embrace ESG tenets may be able to enjoy lower financing costs and higher equity valuations.
How large is the ESG bond market?
Assets under management (AUM) that are considered socially responsible have experienced stunning growth over the last decade. Bloomberg projects that by the end of 2025, more than one-third of global assets under management will be socially responsible.
Most global ESG assets are equity related. Corporate bond markets are considerably behind in terms of adaptation, but they’re growing fast. Bank of America estimates that the AUM in global ESG bond funds is currently $329 billion, with a 104% year-over-year (YOY) growth rate. Over the same period, US ESG bond fund AUM of $34 billion increased 43% YOY. Despite the YOY growth, it’s clear that the US IG market is in the early stage of implementation. For instance, domestic year-to-date IG, ESG-labeled issuance (specifically green, social, and sustainability-linked bonds) represented a mere 6% of new issuance versus 3% for all of 2020. This is compared to 25% of supply in Europe, where ESG bond investing is much more established.
Most of the 1,200 issuers in the ICE BofA US Corporate Index are large public companies of which 385 are also in the S&P 500®, accounting for 84% of its market capitalization. This overlap allows the customization of both bond and equity SMAs using the same screens and data. The transparency provided by this process ensures that an investor’s bond and equity holdings align with their core values—unlike a passive fund, which may not incorporate these ESG considerations.
While many investors appreciate the ability to choose from an extensive menu of ESG screens based on business involvement, others prefer to delegate the issuer-selection process to a team of experienced ESG analysts, like the ones at our affiliate Calvert. These analysts take a holistic view of a company, assessing a wide range of relevant ESG factors known as key performance indicators (KPI) to derive a single score. KPIs are weighted based on their financial materiality and highlight the key aspects of the business most likely to affect financial outcomes. For instance, an energy company will be scored most heavily on its environmental impact while a bank’s governance issues may carry the biggest weight. Although this process is somewhat less transparent, it benefits from a balanced assessment of a company’s KPIs, which can change over time as ESG risks evolve.
Do ESG principles reduce portfolio yield?
In a recent blog post, we showed there was no yield penalty for using an ESG overlay in the municipal bond market. The same holds true for the IG corporate market. For example, a newly invested 1-to-10-year, A-rated, corporate-ladder SMA with no ESG screens yields 1.17%. The same ladder constructed using our environmental screen overlay or the Calvert-approved ESG screen also yielded 1.17%. Being able to apply ESG screens to the entire IG corporate market, as opposed to limiting our investable universe to ESG-labeled bonds that carry a green, social, or sustainable designation, dramatically increases the number of issues that can be considered for inclusion in the portfolio and thus provides better relative value opportunities.
Given the asymmetric nature of corporate bonds, whose prices tend to decline substantially more than they rise, an ESG overlay can provide more protection from downside risk. Companies with higher ESG scores may provide added protection from accounting surprises, regulatory actions, or environmental mishaps.
How do bond investors influence the behavior of corporate issuers?
The positive investment attributes of ESG investing are clear, as is the ability to influence corporate behavior through your investments. In equities, socially conscious investors express their opinions through the exercise of their proxy votes. While corporate bondholders don’t have proxy votes, they can directly influence a company through engagement. Importantly, both bond and equity investors benefit from improvements in ESG behaviors, and there’s seldom conflict. Both Parametric and Calvert engage directly with company management. Happily, there is a growing awareness among companies that engaging in dialogue with ESG-minded investors and improving their ESG behavior will directly improve their balance sheets and lower their financing costs.
The bottom line
ESG investing is a growing trend in the investment-grade, corporate bond market and is gaining momentum. The opportunity to align personal values across both equity and bond portfolios without sacrificing yield—while building a more robust, less volatile bond portfolio—is compelling. We expect that the coming years will see rapid growth.
John Hemingway contributed to this blog post.
The index data referenced herein is the property of ICE Data Indices, LLC ("ICE"), its affiliates, or its third-party suppliers. ICE, its affiliates, and its third-party suppliers accept no liability in connection with its use.