Investors became well versed in funds offering environmental, social and governance (ESG) characteristics last year as their popularity and growth grew rapidly.
However, bonds, and indeed corporate bonds, have been given less coverage in comparison to the long-equity ESG equivalents.
As such, Fong Yee Chan, head of ESG strategy at Vanguard Europe, explains how ESG-conscious investors can ensure that their bond allocation is also in line with their investment goals.
“While equity ESG funds have garnered much of the headlines, as well as the flows, awareness is mounting around ESG fixed income funds,” said Chan.
He said fixed income funds that use exclusionary screens can be a viable option for ESG-conscious long-term investors looking to put together balanced, diversified bond portfolios.
However, like equity ESG funds, there are a number of products on the market with differing aims and focuses.
This, Chan explained, is why selecting the right exclusionary-screened corporate bond fund is important.
“Understanding the underlying exclusionary methodology is important because this dictates the outcomes – both ESG and investment – the product will deliver,” he said.
Vanguard’s ESG Global Corporate Bond UCITS ETF, for instance, tracks the Bloomberg Barclays MSCI Global Corporate Float-Adjusted Liquid Bond Screened index. The fund was launched in May.
Performance of index over 5yrs
Source: Bloomberg
The index includes investment-grade corporate fixed rate bonds from both developed and emerging market issuers. It is constructed according to the same rules as its parent non-ESG benchmark, but with one important difference - it removes issuers according to certain ESG criteria.
These criteria screen companies based on product and conduct research, removing those with ties to activities such as non-renewable energy, weapons, genetically modified organisms (GMOs) and vice products.
Additionally, most of these activities are screened according to a 0 per cent revenue threshold – that is, if an issuer makes any revenue from these activities, they are removed from the index.
Alcohol and gambling, however, are subject to a 5 per cent revenue threshold. This, said Chan, helps to reduce the risk of excluding large diversified companies that make a small part of their revenue through vice products, like supermarkets.
Vanguard’s head of ESG strategy explained that while investors in ESG-screened bond index products will gain exposure to a smaller universe, this won’t affect the diversification benefits.
“Depending on the index, ESG corporate bond indices can exclude more than half of the bond universe by market cap and over two-thirds of the issuers relative to non-ESG benchmarks,” he said.
“This highlights why it’s important for investors to understand the underlying index methodology to ensure it meets the ESG and investment outcomes they are seeking.”
The index that Vanguard ESG Global Corporate Bond UCITS ETF tracks excludes nearly 50 per cent of the bond market cap of its parent index. Despite these exclusions, the index offers investors diversified corporate bond exposure, comprising 5,310 bonds issues by 903 different issuers with mitigating ESG-related risk.
As a result, the performance of screened funds will of course differ from non-screened exposures.
However, while performance may deviate from the underlying benchmark, Chan is clear that it doesn’t compromise the role of bonds in a portfolio.
“For many investors, bonds are a source of stability in a portfolio and our research suggests that whether investors opt for ESG-screened fixed income products or non-screened exposures, this decision neither adds to nor detracts from the shock-absorbing attributes of bonds,” he said.
“A broadly diversified ESG-screened fixed income product can offer considerable diversification.”
The Vanguard ESG Global Corporate Bond UCITS ETF also takes a liquidity-screened approach, applying higher bond minimum issuance sizes relative to the parent index.
“This can help to lower transaction costs as well as the total cost of investing while still offering high levels of diversification,” he added.
Chan continued by saying ESG-screened fixed income products will rarely be held in isolation by an investor – therefore how they work in a portfolio, alongside its other components is key.
“By adopting the Bloomberg Barclays-MSCI index for its Vanguard ESG Global Corporate Bond UCITS ETF, Vanguard has a consistent index provider across all of its fixed income products. This allows ESG-conscious investors to build low-cost, diversified bond portfolios by combining ESG and non-ESG exposures.”
He added that the fund can also be combined in portfolios with Vanguard’s ESG equity index funds, which apply exclusions that are closely aligned to Vanguard’s approach to exclusionary index investing.
“Most importantly, ESG investing should not mean deviating from sound investment principles,” he said. “ESG is not a reason for investors to pay much higher fees, nor to be encouraged into high-risk strategies."