The Name is Bond, ESG Bond

ESG revolution continues to spread 

The rise of Responsible Investing has transformed equity markets for both issuers and investors over the past five years. However, fixed income markets have historically lagged behind in terms of environmental, social and governance considerations – until recently.

Based on recent data, it appears the ESG revolution has finally entered the bond universe. Proceeds of US corporate bonds issued with an ESG label increased to $162.9 billion year-to-date, up from $100.5 billion during the same period in 2020 and $44.3 billion in 2019.¹ While this pales in comparison to the broader ESG market of $35 trillion,² the trend does demonstrate a key shift in the demand and delivery of bond issuances. Namely, that the benefits of responsible investing – which are well-known on the equity side – are magnified when applied to the small, but growing subset of ESG fixed income issues.

Why equities led the charge 

Responsible investing first gained traction by taking the contingent liabilities previously covered in footnotes and integrating them into the equity screening process. Risks that did not appear on the balance sheet, or were relegated to the inner pages of an annual report, came to light as investors began asking tougher questions on ESG issues. This newfound transparency often revealed hidden risks that could hurt a company’s earnings and potentially damage the reputation of an investor with a fiduciary duty to act in the best interests of the client. 

In fact, a seminal report published by the UN Global Compact and UNEP Finance Initiative states unequivocally that, ​“Failure to consider long-term investment value drivers, which include environmental, social, and governance issues, in investment practice is a failure of fiduciary duty.”³ The report goes on to say that Canada’s largest pension funds have demonstrated strong engagement on long-term issues, but that Canadian asset owners generally trail behind their European counterparts when it comes to ESG considerations. The challenge facing a family office or investment counselling firm is how to bridge the ESG gap when they lack the scale and resources to engage like a pension plan.

Why bonds lagged behind

The discrepancy between equities and fixed income can be traced to proxy voting and shareholder engagement, according to a recent report.⁴ Consider the differences: equity managers who buy a company’s shares have an obligation to act in their clients’ best interests. They are invited to comment on pivotal changes related to the firm’s future, whereas fixed income portfolio managers (PMs) are not investing but rather lending money in order to generate yield. There is no ownership, no engagement, no voting. As a result, bond investors may believe they wield no influence over their holdings. They may settle on integrating ESG factors through implicit, rather than explicit, engagement due to a vital misperception about their own role as a lender. 

Re-thinking ESG bond allocations

The above thinking is flawed, of course, because both owners and lenders should be equally interested in identifying off-balance sheet risks. By nature, equity managers may focus on the ​“returns” side of the equation. In contrast, bond managers are typically more concerned with capital preservation, and will spend time hunting for a stable return stream to inoculate against risks to cash flow. Safety is more inherent to their role – not less. Some will argue that because bondholders have a higher claim on assets in the case of bankruptcy, they face less ESG risk. While this might be true at a micro level, when you pull back to look at the bond market from a macro perspective, the risk is far greater. According to the Securities Industry and Financial Markets Association (SIFMA), as of 2021 the total debt outstanding worldwide is estimated to be $119 trillion and $46 trillion for the U.S. market alone. This compares to the current market capitalization of the S&P 500 of roughly $40 trillion. At the aggregate class level, ESG issues are an issue that bond market participants must consider.

The need for greater prudence also stems from record low interest rates. It’s no secret that corporate bond issuances are at historic levels due to a flood of cheap money from central banks. Nor is it a secret that this trend is set to continue for the foreseeable future. On this fact alone, fixed income managers should feel compelled to apply greater pressure and scrutiny on the borrowing entities, particularly for long-dated securities that have a greater likelihood of being affected by an ESG-related risk.

Case in point: One of the largest cruise ship operators in the world has been an active issuer of high yield bonds since the pandemic began. This is a company that derives revenue from sailing tourism. Would it be reasonable to assume that extreme weather events related to rising sea temperatures could negatively impact its business? An ESG lens would at least consider the question, while a conventional approach may overlook the impact of non-financial factors. 

The scope of climate-related risks is so broad that even ​“risk-free” sovereign bond issuers, such as the United States and Canada, cannot be counted as immune. In fact, a number of large asset owners are currently working with UN organizations to establish a framework to assess the climate risks at the nation-state level. 

In general, fixed income managers also invest in smaller and lower-rated companies than equity PMs, leaving them as the only voice at the table and providing the bond manager an outsize influence over management decisions. 

Obstacles to implementation 

For the family office or investment counselling firm looking to implement ESG on the fixed income side of their public investment portfolios they must take stock of certain considerations: How much time can you dedicate for research? What are the costs? Could tracking error become a problem? 

All fixed income ESG solutions induce some slippage, but the question is how much? A family office or investment counselling firm might choose solutions like green bonds and sustainability-linked notes which trade in the over-the-counter (OTC) bond markets, where liquidity constraints can sometimes be a problem. 

Family offices and investment counselling firms also face the time and financial drain of continuous due diligence. To monitor the ESG risks among bond issuers, they must subscribe to expensive data providers, such as MSCI or Sustainalytics (a Morningstar company) and trust third party screeners for strategic insight. These sources have unique – and often inconsistent – understandings about ESG requirements. The fact is Responsible Investing means different things to different people, and even with a third party ESG filter, a family office and investment counselling firm will still end up with a bond portfolio based on arbitrary standards. These discrepancies open up them to reputational risk, and a potential violation of their fiduciary duty.

Passive ESG bond ETFs offer an answer

We believe an Index bond ETF is the best solution for building ESG bond exposure, not only because it’s liquid and trades on an exchange, but for the ease of implementation as well. For example, the benefits include: 

• Greater stakeholder consensus. Indexes are made of rules which are transparent, consistent and publicly available and all members of the family/​clients of the firm, can agree or not and move forward with consensus.
• Less tracking error. Using index based ESG bond ETFs reduces the slippage that typically comes with having to buy and sell individual green bonds or sustainability linked notes.
• More consistency. As mentioned earlier, working with multiple active managers can result in contrasting rules and standards. Meanwhile, an index-based strategy provides uniformity across all geographies and mandates.
• Fewer ​“greenwashing” surprises. Indexing allows for straightforward monitoring of ESG performance at the company and portfolio level, which can help avoid any confusion about ESG criteria.

Ultimately, a fixed income ESG ETF is not designed with a particular outcome in mind. It’s not limited to ​“Green” bonds, but rather includes companies whose business models have met objective ESG standards; this is a broader universe. The stated goals of the MSCI ESG Leaders Methodology, which underpins the strategies below, is to help investors fulfill a fiduciary obligation while cleansing their capital. So, while the emergence of an ESG bond revolution may have been late compared to the equity market, I say it’s better late than never for the family office and investment counselling firm looking for a simple way to incorporate ESG bond screens via an ETF

• BMO ESG Corporate Bond Index ETF (Ticker: ESGB)
• BMO ESG US Corporate Bond Hedged to CAD Index ETF (Ticker: ESGF)
• BMO ESG High Yield US Corporate Bond Index ETF (Ticker: ESGH.F)

Responsible Investing Cheatsheet

Responsible is a broad term that includes the following sub-categories:

¹ More CFOs Add Sustainability Targets to Corporate Loans, Wall Street Journal, September 20, 2021.

² ESG Investors Warned of ​‘Shock’ Ahead Without Shift in Strategy, BNN Bloomberg, August 30, 2021.

³ Fiduciary Duty in the 21^st Century, UNEP, last accessed October 6, 2021.

⁴ ESG Considerations in fixed income: Rapid expansion trend continues, Russell Investments, July 5, 2021.