On the back of strong demand for green bonds, a passive expert at Morningstar explains why it is important to ‘look under the bonnet’ when sizing up ETFs in this area.
Investor interest for bonds that focus on environmental, social and governance (ESG) factors continues to grow. In part driven by regulatory pressures, there is also a growing acceptance among investors that the management of ESG risks may make bond issuers less vulnerable to credit-rating downgrades or default. And in the world of fixed income investing, this matters greatly.
The expectation that ESG could help mitigate credit risk, coupled with the rising popularity of low-cost passive investing, is the perfect mix of conditions for further growth of the ESG ETF bond offering in coming years.
In the first half of 2022, flows into bond exchange-traded funds (ETFs) amounted to €8.3 billion (£6.9 billion), of which €7 billion was directed to funds tracking ESG indices. It is likely to be the first year where most flows into bond ETFs in Europe are allocated to ESG strategies.
Assets in ESG bond ETFs already represent 17% of total assets invested in bond ETFs in Europe on a combination of flows into newly launched products and switches of mainstream bond ETFs into ESG propositions.
Most assets in bond ESG ETFs in Europe are invested in funds that provide exposure to the corporate bond market, with the lion's share in ETFs that track indices covering issuers with an investment-grade credit rating.
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The dominant status of corporate bonds in the realm of bond ESG ETF investing is unlikely to be challenged anytime soon. However, what is starting to change is the way investors express their ESG preferences.
How ESG bond ETFs invest
ESG corporate bond ETFs have typically tracked indices constructed on a basic formula that involves the exclusion of issuers involved in controversial activities, for example: tobacco, gambling, controversial weapons. This is combined with a “best-in-class” selection underpinned on the analysis of a large number of metrics covering the three pillars of the ESG spectrum, that is environmental, social and governance.
More recently, however, we have seen the emergence of Paris-aligned benchmarks (PAB), which are specifically aimed at investors who seek to implement a net-zero strategy in their portfolios. The key objective of these indices is to address climate change.
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Paris-aligned indices are aligned with a 1.5°C temperature-rise scenario and incorporate the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). They also typically incorporate an optimiser that analyses multiple metrics to assess the decarbonisation path of the companies included in the basket, with the aim of favouring those that excel in this goal and penalising the laggards.
Compared to standard ESG bond indexes, the overriding focus of Paris-aligned benchmarks is on the environmental or “E” pillar of the ESG spectrum. Because of their targeted decarbonisation investment objective, ETFs tracking Paris-aligned benchmarks typically qualify as Article 9 funds as per the nomenclature introduced by the Sustainable Finance Disclosure Regulation (SFDR).
By contrast, ETFs tracking standard bond ESG indices are usually classed as Article 8 funds, which promote broad environmental, social or good governance characteristics. Meanwhile, bond ETFs that track non-ESG indexes are classified as Article 6 funds.
As of now, the offering of ETFs tracking Paris-aligned bond benchmarks in Europe is small with just five funds, all launched since 2021. Their combined assets of €2.3 billion account for just 1% of all assets invested in bond ETFs in Europe. However, in the first half of 2022 these funds attracted close to €800 million of inflows, or 11% of the €7 billion netted by bond ESG ETFs during the period. This signals growing interest in these strategies and bodes well for the launch of new products.
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Many assume that anything classed as Article 9 should by definition be “more green” than Article 8. However, this is a misconception. The difference between the two groups lies in the nature of the investment objective, with Article 9 funds having a more narrowly defined goal that eyes an impactful outcome, for example, decarbonisation. But by targeting the “E” pillar, Paris-aligned bond Article 9 ETFs can fall short of delivering on the “S” and “G” pillars relative to standard ESG Article 8 bond ETFs. One can be forgiven for feeling confused!
The evolving nature of ESG bond investing is welcome, but it reinforces the need for stringent due diligence on the indices that ETFs track and not to be misguided by nomenclature and labels. To put it differently, “greenness is in the eye of the beholder”.
The starting point is always to clearly define what we want from our ESG bond investment. If it is to address each aspect of ESG broadly equally, then an Article 8 ETF likely remains the best option. If, by contrast, it is decarbonisation, while potentially compromising on the “S” and the “G”, then a Paris-aligned bond ETF would better fit the bill.
Jose Garcia Zarate is associate director, passive strategies, manager research, Europe, at Morningstar.
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