Sustainable investing has been gaining a lot of attention. Given the growing number of products, data availability and academic research suggesting investors may not need to sacrifice return, one could argue it is no longer just a ‘feel good’ exercise and that it has become more mainstream.
For investors who want their investments to align with their environment, social and governance (ESG) values, there have been plenty of index and active stock strategies to choose from for years. As of 31 March 2017, investors have over $200 billion invested in total assets in equity mutual funds and exchange-traded funds (ETFs) that are designated as socially conscious or sustainable (source: Morningstar). However, fixed income investors have not had many sustainable investment choices. This is in part due to the fact that most research in this space has centered around stocks. Although bonds do not have voting rights, ESG considerations can be applied to the construction of bond indexes similar to how they are for equity indexes.
In our view, investors incorporate sustainable investing into their portfolios for three primary reasons:
- To align with ethical or political values
- To integrate ESG considerations to potentially enhance returns
- To target specific outcomes such as clean energy or gender equality
Some investors focus on just one of these objectives, while others will take a combined approach.
In the simplest terms, sustainable investing is about having a long-term view. When you screen a company through ESG lenses, you are essentially weighting the potential impact of its practices on the long-term well being of the world across environment, social and governance spectrums.
Does the company think about its environmental and financial impact with regard to climate change, pollution and waste? How does the company manage against these key risks?
Does the company treat its employees well and have a positive impact on the community? What is the company’s impact on human capital, product liability, stakeholder opposition and other social opportunities?
How well managed is the company? Does it have appropriate incentives and sound processes? Does corporate governance, such as board structure, ownership and accounting, promote good corporate behavior?
These ESG considerations can potentially translate into better long-term financial performance as they help to identify risks and opportunities that are not well captured by traditional financial analysis. For example, issuers that are less exposed to risks due to environmental issues (E), or are better able to attract and retain skilled workers (S), or have stronger corporate governance (G) could potentially outperform peers in their respective industry in the long run. This longer-term view especially lines up with the typical investment horizon of bond investors.
ESG index and ratings
With demand for sustainable investing growing significantly, ESG data—also termed nonfinancial data—has become a prominent business. MSCI, a leading provider of indexes and research, rates companies on an “AAA” to “CCC” scale according to their exposure to ESG risks. These ratings are based on robust data generated by over 150 research analysts and undergo a committee review.
These ratings can be applied to bond issuers to develop an index that includes issuers with more favorable ESG scores. For example, the Bloomberg Barclays MSCI U.S. Corporate ESG Focus Index contains bonds from corporate issuers with higher ESG scores relative to the broad corporate bond market. As detailed in the diagram below, almost two-thirds of the bonds in the index have issuers with MSCI ESG scores in the leader (AAA or AA) category. This approach makes for a bond index that resembles its parent index from a yield potential and duration perspective, but results in an ESG uplift.
Bloomberg Barclays MSCI US Corporate ESG Focus Index
For investors who are looking to use ETFs to incorporate ESG considerations into their bond allocation, consider iShares ESG USD Corporate Bond ETF (SUSC) and iShares ESG 1-5 Year USD Corporate Bond ETF (SUSB), which are the first U.S. ESG corporate bond ETFs to the market.
Learn more about how consistent investment performance and low fees are critical to achieving your fixed income goals in today’s environment.