Gaining Ground in ESG Fixed Income

For years, fixed income has lagged behind equities in the field of environmental, social, and governance (ESG) investing. But things are changing: of the €16.1 billion in inflows that have been recorded in European-domiciled fixed-income ETFs so far in 2022, ESG funds have captured €13.6 billion, attracting 84% of the entries into fixed-income funds.

The demand for ESG bonds is increasing significantly. And also the variety of efficient passive ESG fixed-income solutions. As investors consider the benefits of incorporating ESG criteria into fixed income, this segment offers an ever-widening range of investment opportunities.

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ESG in fixed income: catching up quickly

The first ESG equity index was launched in 1990, but the first ESG bond index did not appear until 2013. Since then, compared to equities, progress in integrating ESG considerations into bond portfolios has been slow, partly due to engagement factors. Bondholders lack the voting rights that shareholders have, fueling the myth that they have limited ability to participate in and influence companies.

Of course, success in bond investing is defined more by avoiding losers than choosing winners – integrating ESG considerations into bond portfolios can help with this challenge, reducing risk and potentially improving returns. And companies that regularly raise funding through bond issues are increasingly recognizing the benefits of listening to bondholders.

As more and more investors have recognized the virtuous circle, the demand for ESG fixed-income solutions has grown. Between the end of 2019 and the end of September 2022, the AUM in European Fixed Income ESG ETFs rose from €20.1bn to €55.2 billion.

Incorporating ESG analysis into fixed-income investing carries several potential benefits

ESG scrutiny of a bond issuer can reveal exposure to long-term investment risks, such as climate change, that can take years to materialize. Furthermore, several studies suggest that companies with strong ESG credentials are less likely to default and more likely to be profitable in the long run.

For this reason, managers have worked to develop solutions that integrate ESG into fixed income. ESG factors are playing a greater role in credit ratings, and bond investors are increasingly engaging directly with companies, holding them accountable on ESG issues. Bondholders recognize that the lack of voting rights held by equity investors does not diminish their right as interested parties to engage with issuers. Eager to attract ESG investors and achieve inclusion in major ESG indices, bond issuers are now much more forthcoming with information.

Another factor is the better data availability from ESG information providers in areas that were previously less covered, such as sovereign bonds. For various reasons, including a lack of consistency in the measurement of material ESG factors and less developed ESG tools or practices, government debt lags credit in terms of ESG integration. However, increased investor scrutiny on ESG issues is driving progress in this area.

Thus, the move towards greater ESG integration in fixed income has gained new momentum, along with increased investor adoption of ESG fixed-income ETFs.

ESG: mainstream in 2022

Recent events have brought ESG issues to the fore: Covid and market turmoil tested portfolios’ resilience, causing many investors to reassess their fixed-income allocations. ETFs stood out amid the volatility, demonstrating their agility and resilience. Bond ETFs trade in large volumes, even in segments with dwindling liquidity. Monetary authorities, including the Federal Reserve, Bank of England, and Bank for International Settlements, recognized their versatility by highlighting the role of ETFs in pricing, especially fixed income. The pandemic has also sharpened investor focus on ESG, with €18.1 billion in inflows into European fixed-income ESG ETFs over the past 12 months.

ESG Fixed Income ETFs: Strong growth and innovation in sight

In our view, the growing investor appetite for ESG fixed-income ETFs will continue to drive product innovation and investor choice. Despite recent gains, we see great opportunities for fixed income to further increase its share of sustainable assets globally.

Investors are increasingly embracing ETFs as their vehicle of choice for implementing ESG fixed income into portfolios, and we expect continued innovation and assets under management in these dynamic tools to increase. Ultimately, this should lead to a greater bid for investors, enhancing their ability to embed sustainability into portfolios and reflecting their investment beliefs and objectives.

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(Featured image by Austin Distel via Unsplash)

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