Every April 22, millions of people celebrate Earth Day by finding ways to make more sustainable choices in their lives. If you’re one them, don’t forget to look at your bonds.
In an effort to “reduce, reuse and recycle,” I have switched from disposable coffee cups to an amazing stainless-steel tumbler that keeps my drinks hot or cold for hours. Just as importantly, I have finally trained my brain to remember to bring it to work with me.
Like cutting down on coffee cup usage, adding sustainable investments to a portfolio takes a bit of preparation. Fortunately, it’s almost as easy to put into action.
More than stocks
One way that is growing in popularity is the use exchange traded funds (ETFs) that seek to track environmental, social and governance (ESG) indexes. ESG data providers collect information on companies and rate them with an ESG score. Index providers use these scores as the basis to determine which securities are included in an index and may apply negative screens to exclude certain sectors such as weapons manufacturers or tobacco companies.
While people often associate ESG or sustainable investing with stock funds, a similar approach can be used for bond portfolios, too. As with stocks, bond issuers can be rated on distinct ESG characteristics and in turn, the bonds from these issuers. Indeed, ESG analysis has become increasingly important in credit ratings themselves. As demand has grown, credit ratings agencies have been exploring ways to incorporate ESG analysis in their ratings, and some have already started doing so.
Let’s look at two approaches to investing in more sustainable bond issuers: ESG and green bonds.
1. Go broad by applying an ESG lens
ESG analysis is about identifying risks and opportunities that may not be captured in traditional financial analysis. For example:
- Environmental–focuses on the use of scarce natural resources, energy usage and pollution
- Social–focuses on how a company treats its workers, data privacy and product safety
- Governance–focuses on business ethics, board structure, executive compensation and accounting practices
It’s important to note that when data providers such as MSCI rate companies, they do so based on ESG characteristics that are most relevant to their industry. For instance, an issuer’s environmental impact would be more important for an oil company, while a bank would be more closely judged on the social impact of its lending practices.
The creators of ESG bond indexes take these ratings into consideration to determine whether or not these companies make it into the index and at what weighting. Depending on the construction of the index, other factors are used to seek a certain target, such as a similar risk and return profile as the relevant broad market benchmark.
For example, guidelines can be set so that the ESG index adheres to certain sector weightings, credit ratings and duration targets. Screens on a company’s business involvements like tobacco and weapons can also be applied, in addition to companies that experience a severe ESG controversy (e.g. a massive oil spill or product recall).
A broad ESG approach that seeks a similar risk and return profile as the relevant broad market benchmark allows investors to use these funds as portfolio building blocks–much as they would a traditional bond ETF.
2. Green bonds
Green bonds are an even more targeted approach to investing sustainably and are often known as “impact” investments, since proceeds proactively and directly fund sustainable projects. These bonds–issued by foreign government agencies, supranational issuers or corporations–are used to fund new and existing projects that promote environmental purposes. Think solar panels or clean transportation.
While there is no governing body that determines whether an issue is “green,” the Green Bond Principles are voluntary process guidelines that encourage transparency and disclosure and promote integrity of the green bond market. It’s important for investors to ask how these issues are being evaluated and for reporting that details the impact from the use of the bond’s proceeds. A green bond ETF makes it easy for investors to gain diversified exposures to these projects.
Funds to consider:
- iShares ESG U.S. Aggregate Bond ETF (EAGG)–Seeks to track an optimized version of the Bloomberg Barclays U.S. Aggregate Bond Index, which includes corporate bonds, mortgage-backed securities, U.S. Treasuries and other investment grade bonds. (ESG scores are applied only to the corporate bond issuers, as MSCI doesn’t rate the U.S. government.)
- iShares ESG USD Corporate Bond ETF (SUSC)–Holds corporate bonds with maturities of greater than or equal to one year.
- iShares ESG 1-5 Year USD Corporate Bond ETF (SUSB)–Holds corporate bonds with maturities of 1 to 5 years.
- iShares Global Green Bond ETF (BGRN)–Seeks to track the Bloomberg Barclays MSCI Global Green Bond Select (USD Hedged) Index.
Karen Schenone, CFA, is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group and a regular contributor to The Blog.
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International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
A fund’s environmental, social and governance (“ESG”) investment strategy limits the types and number of investment opportunities available to the fund and, as a result, the fund may under-perform other funds that do not have an ESG focus. A fund’s ESG investment strategy may result in the fund investing in securities or industry sectors that under-perform the market as a whole or under-perform other funds screened for ESG standards.
A fund’s use of derivatives may reduce a fund’s returns and/or increase volatility and subject the fund to counter-party risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that any fund’s hedging transactions will be effective.
The iShares Global Green Bond ETF’s green bond investment strategy limits the types and number of investment opportunities available to the Fund and, as a result, the Fund may under-perform other funds that do not have a green bond focus. The Fund’s green bond investment strategy may result in the Fund investing in securities or industry sectors that under-perform the market as a whole or underperform other funds with a green bond focus. In addition, projects funded by green bonds may not result in direct environmental benefits. Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.
Diversification and asset allocation may not protect against market risk or loss of principal. Buying and selling shares of ETFs will result in brokerage commissions.
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