04 May 2021

ESG credit: A simple switch for ‘best in class’ bonds 

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For Marketing Purposes - ​FOR QUALIFIED INVESTORS ONLY– This document is reserved and must be given in Switzerland exclusively to Qualified Investors as defined by the Swiss Collective Investment Scheme Act of 23 June 2006 (as amended from time to time, CISA).

For bond investors, success is defined less by picking winners than by avoiding losers. Integrating ESG considerations into a bond portfolio can help with this challenge, reducing risk and potentially improving returns. In this blog, we will examine how an environmental, social, and governance (ESG) filter can improve the quality of corporate bonds in a portfolio, and how this can help secure future income and reduce default risk. 

In our last article (Financing the future: how bond markets can help build a better world) we talked about ‘sustainable bonds’ and briefly outlined two types that can contribute to positive ESG or climate outcomes. One is green bonds, and the other – which we will look at in greater detail today – is ESG-screened corporate bonds (‘ESG credit’).

What is ESG credit?

ESG credit takes a mainstream corporate bond benchmark (the ‘parent index’) and applies a sustainability screen that includes extra environmental, social, and governance (ESG) standards. This screen or filter excludes any bonds issued by companies with poor ESG ratings, or who are subject to very severe scandals, or involved in controversial business such as weapons, tobacco, thermal coal and unconventional oil and gas.  

The power of corporate bonds

Issuing corporate bonds is one of the main ways that the world’s companies raise money. Through the bond market, corporations raise billions of euros each year to finance their business and grow. To reward investors for providing these loans, the issuer provides a regular payment (the coupon) and returns the investor’s loan (the principal) when the bond matures.

Most companies need credit to scale up and innovate with new products and markets. They regularly return to the corporate bond market to issue new bonds, which helps explain why this market makes up about one third (€34trn) of the €100trn bond universe1.

Given the large sums involved, and the fact that companies must regularly approach the market for more, bond investors have huge power to change corporate behaviour. And, as we’ll see now, better corporate behaviour is good news for bond investors who want to improve long-term returns.

Why bond investors should care about ESG too

Unlike equity investors, bond investors aren’t driven by the need to pick outperformers. Their priority is more to avoid losers, receive their initial investment back, and benefit from the regular income promised by the issuer in the meantime.

The question is then: what could stop the issuer providing this income? Or in other words, what major risks are there to corporations’ future cashflows? What could, in the worst case, make them default on their debt entirely? 

In our view looking at long-term risks, some of the main issues nowadays are encapsulated within the three letters ‘ESG’. Whether it’s how a company adapts (or doesn’t) to environmental issues, how it manages social responsibility, or conducts its corporate governance, it all hinges on ESG. If you’re a bond investor, you want to make sure that your bond issuers aren’t sleepwalking into disaster. Given the capped upside of bonds compared to equities, a default can be devastating for performance.

ESG credit funds address this problem by taking into account extra-financial ESG criteria, aiming to build a ‘best in class’ corporate bond exposure that could help reduce the risk of major scandals or corporate mismanagement affecting bond performance. Our ESG credit ETFs exclude all companies involved in serious controversies, as these can become progressively more dangerous to corporate financial stability (a controversy which leads to major fines can, in turn, cause bankruptcy).

The best part is that ESG indices can deliver risk/return benefits with a high correlation and low tracking error to non-ESG indices. That makes it very simple to switch a bond allocation to ESG. 

What took so long?

At the start of the ‘ESG shift’, investors mostly applied sustainability analysis to equities. There are several reasons why, including the perception that bond investors have less power to engage with companies and influence change, as they are lenders rather than co-owners.

With equities, the thinking went, an investor could vote at shareholder meetings and influence the behaviour of companies to encourage them towards more sustainable business practices. 

Not to mention that executive pay is often linked to stock price performance, so moving a company’s stock price can exert extra influence on senior management.

However, in terms of market value, the bond market is far larger than the equity one2. And ESG scores that provide important benefits to equities – often leading to better risk/return and positive impact – can be applied to corporate bonds too.

That’s why institutions like the UN PRI have emphasised that responsible investors should apply ESG across asset classes – not just focus on equities.

This has led investors to understand that an ESG strategy implemented through equities alone addresses just one part of the challenge – and it doesn’t fully satisfy a goal to be responsible and ESG-focused. So, with the success of ESG equity investing well established, investors are now striving to replicate that success with bonds.

How investors started the ‘ESG shift’

ESG isn’t new, but 2020 was undoubtedly a turning point for sustainable investing. Over $120bn in net new assets went into sustainable funds in Q4 2020, according to Morningstar data. Flows across the whole of 2020 were “almost five times higher than three years ago.” 

European Sustainable Fund Flows by Asset Class (Morningstar data)

morningstar flows

Source: Morningstar Direct, Morningstar Research. Data as of December 2020. 

As an exchange-traded fund (ETF) provider, we look more closely at ETFs. In Europe last year, ESG ETFs gathered more than half of all ETF flows, gaining €45.5bn compared to €43.8bn for non-ESG ETFs. ESG ETF flows in 2020 were more than double the figure in 2019.

ESG ETFs

Looking specifically at bond ETFs, we’ve seen steady flows into ESG bond ETFs since the start of 2020, even through the height of the Covid crisis in March 2020. 

Flows into ESG and non-ESG fixed income ETFs, January 2020 – March 2021

In millions (USD) 

Flows into ESG and non-ESG

Source: Lyxor International Asset Management, as at 21/04/2021. 

To recap: at the beginning of this article, we explained our view that there’s a strong case for bringing ESG considerations into bond allocations – and that doing so is a central part of being a truly responsible investor. In the section above, we’ve seen that the ‘ESG shift’ is now well underway. Next, let’s look at one way to integrate ESG into a bond allocation.

ESG credit: Lyxor’s approach

We are one of Europe’s leading ETF providers with a long-standing focus on ESG, climate, and thematic investing. We believe in the power of ETFs to democratise investing and put low-cost, effective investment solutions in the hands of anyone who needs them.

Our approach to building ESG credit ETFs uses three layers of ESG screening applied to Bloomberg Barclays bond indices. We start with a parent index – for example, the Bloomberg Barclays Euro Corporate Bond Index. We apply a liquidity filter, then the following exclusions:

note

Issuers with no ESG rating or a low ESG rating are excluded based on MSCI ESG Ratings done at peer-group level (see ‘MSCI ESG Ratings’ table below). Issuers rated with ESG rating below BBB and non-rated issuers are excluded. 

Controversial businesses

Issuers involved in controversial businesses are excluded using a revenue-based approach. This is based on MSCI ESG Business Involvement Screening Research and additional fossil fuel-related filters3.

Severe controversies

Finally, issuers subject to severe controversies are excluded based on the MSCI ESG Controversies Score, where any companies subject to major controversies classified as “Red” are excluded.  

Understanding the ESG screening methodology

MSCI ESG ratings diagram

The full ESG screening process

ESG screening flow diagram

Reasons to consider switching from non-ESG to ESG credit

1. Recent history shows ‘ESG leaders’ are better in a crisis

Top ESG issuers fared better during the March 2020 market volatility…
Period: 28/02/2020 – 31/03/2020, perf in USD

ESG buckets performance chart

Source: Lyxor International Asset Management, Bloomberg Barclays, MSCI. USD corporate universe performance of each ESG bucket relative to Bloomberg Barclays US Corp Index. For illustrative purposes only. Past performance does not predict future performance. Data as of 31/03/2021. ESG rating considered as of 28/02/2020.

… and ESG credit offers more exposure to top ESG issuers

Euro investment grade corporate bonds - ESG rating breakdown vs parent index

nvestment grade ESG ratings

Euro high yield corporate bonds - ESG rating breakdown vs parent index

High yield ESG ratings

Source for both charts: Lyxor International Asset Management, Bloomberg Barclays, MSCI. For illustrative purposes only. Data as at 01/03/2021.

2. Better credit rating compared to parent indices 

Euro investment grade (IG) corporate bonds - Credit rating breakdown vs parent index (% market value) 

 Investment grade Credit Ratings

Euro high yield (HY) corporate bonds - Credit rating breakdown vs parent index (% market value) 

 High yield Credit Ratings

Source for both charts: Lyxor International Asset Management, Bloomberg Barclays, MSCI. For illustrative purposes only. Data as at 01/03/2021. 

3. No major biases compared to parent indices

Euro investment grade (IG) corporate bonds - Similar yield and duration profile vs parent index

Page 8 - Investment grade Profile Comparison.png

Euro high yield (HY) corporate bonds - Similar yield and duration profile vs parent index High yield Profile

Source for both tables: Lyxor International Asset Management, Bloomberg Barclays, MSCI. For illustrative purposes only. Data as at 01/03/2021.

Our ESG credit ETFs at a glance

This has been a quick introduction to the case for ESG investing in corporate bonds. We believe that ESG credit is the natural choice for responsible investors and the next logical step for ESG investing. A new generation of indices and ETFs makes this change as easy as a simple switch. Please get in touch if you’d like to learn more, or visit our ESG Hub to explore Lyxor’s SFDR 8 compliant* ESG credit range. 

Source: Lyxor International Asset Management, 28/04/2021. 

Webcast with Bloomberg, 25 May – you’re invited

Register now for our upcoming webcast with Bloomberg on 25 May, “Why switching to ESG corporate bonds is a natural choice”. You will hear from Mahesh Bhimalingam, Chief European Credit Strategist for Bloomberg Intelligence for a credit market outlook, and David Mendez-Vives, Senior Quantative Analyst at Bloomberg for insight on the application of ESG to corporate bond indices.

If you’d like to learn more about these exciting topics, please book a spot. 

*SFDR: Sustainable Finance Disclosure Regulation.

This article is for informative purposes only, and should not be taken as investment advice. Lyxor ETF does not in any way endorse or promote the companies mentioned in this article. Capital at risk. Please read our Risk Warning below.

1 Source: ICMA, August 2020 https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/bond-market-size/ USD conversion to EUR calculated on 27/04/2021.
2 Global bond market ($128.3 trillion) ICMA https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/bond-market-size/, global equity market ($109 trillion) World Federation of Exchanges https://www.world-exchanges.org/news/articles/full-year-2020-market-highlights
3 Controversial businesses include: Alcohol, Tobacco, Gambling, Adult entertainment, GMOs, Nuclear power, Civilian firearms, Military weapons, Thermal coal, Unconventional Oil & Gas. Source: Lyxor International Asset Management, Bloomberg Barclays, MSCI, as of April 2021. For illustrative purposes only.

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