Climate change. Corporate scandal. Changing public attitudes. Investors today must grapple with a unique mix of challenges – ones that make climate action, good corporate governance, and social responsibility more important than ever in their portfolios.
That’s why environmental, social and governance (ESG) investing has become so important in recent years. For investors of all sizes, ESG increasingly holds the key to managing risks and making better long-term investment decisions. The greatest challenge investors face today is how to incorporate these three letters into their investment process.
For much of its history, ESG was the domain of equity investors. ESG research within fixed income didn’t receive the same level of attention. But more recently, the research has been moving at a blistering pace – and the supportive data has finally caught up.
Today there’s a €100trn opportunity1 for investors, big and small, to unleash the transformative power of fixed income and change the world for the better. In this blog, we’re going to examine this opportunity, and demonstrate two ways to approach it.
Bonds are powerful tools for change
Exciting stories about big-name companies keep us tuned in to podcasts and visiting news sites. But the bond market, less discussed outside of the financial press, is arguably more important than its more newsworthy peer given its larger size (by market value).
Millions of investors use bonds to diversify their risk and reduce volatility. They are a central part of governmental and corporate funding – not to mention the bread-and-butter investment for some of the world’s biggest asset managers, such as pension funds and insurers.
There is a huge amount of money in the bond market. More than 25x the entire yearly US Federal Budget, in fact1. That money has transformative power – power which, if unlocked, would undoubtedly improve the world we live in. Policymakers recognise this potential. That’s why policies and regulation have been changing to encourage a major shift towards responsible investments.
For example, the EU Action Plan was created to build a sustainable future for Europe, the Sustainable Finance Disclosure Regulation (SFDR) was rolled out to tackle the “greenwashing” of financial products, and Article 173 in France requires institutional investors to better report ESG and climate-related considerations in their investment process.
If these initiatives successfully shift the huge pools of money into highly ESG-rated, climate-friendly companies, we expect ‘ESG leaders’ to see their cost of financing go down, enabling them to do more good work and grow. The climate-polluting, poorly-governed ‘ESG laggards’ will get less money from investors, increasing their cost of funding and encouraging them to change their behaviour. A virtuous circle should be the result.
A shift of this scale could radically improve the world we live in. Investors will earn their returns with a clear conscience, knowing they are helping to build a world fit for future generations. Best of all, any investor can join this movement and play a part in securing the safety of our planet.
Changing our unsustainable path
There’s no doubt that companies, governments, and even whole societies today are squaring up to a host of urgent environmental, social and governance challenges.
The most obvious of them is the ‘E’ of the environment. The threat of global warming demands an immediate revolution to reduce carbon emissions, and investors increasingly recognise their responsibility to fight climate change by ‘shifting the trillions’ into climate-friendly companies and investments. Furthermore, governments’ regulations to address climate change will have a negative impact on operational costs and demand for carbon-intensive products such as fossil fuel-based energy production or coal mining.
But ESG is about more than the environment. It ties together different factors to give an overall picture of sustainability and societal impact. Companies must better manage their carbon emissions, resource consumption, and waste production. Investors increasingly recognise that they should also commit to eliminating exploitative practices, such as child labour and modern slavery, in their business and supply chain. They should manage their relationships constructively with local communities wherever they operate, promote diversity and support health and safety. These beliefs find their place in the ‘S’ of social issues, which left unaddressed can impact credit worthiness.
Then there is the ‘G’ of corporate governance – how companies manage themselves. If a company governs itself poorly, there can be a disastrous impact on their reputation, performance, and stock price. Look no further than the Wirecard or Wells Fargo scandals for evidence. Whether it’s executive pay, bribery and corruption, fraud, director independence, board diversity, or tax structure, ‘G’ factors are a key consideration for responsible investing, and they can have strong links to credit strength.
As we’ve seen, until recently, investors were only really able to address these issues with their equity allocations. But that is all changing.
Make a difference with your bond investments
There’s a useful shorthand for ‘bonds that make a difference’: sustainable bonds. This term includes several approaches to fixed income investing that can contribute to positive ESG or climate outcomes.
As an ETF provider, we offer two main routes to responsible bond investing that align with the tenets of rules-based indexing – transparency, diversification and liquidity.
ESG bonds start with a mainstream corporate bond benchmark used by investors worldwide and already invested with billions of euros – known as the “parent index”. Then, a sustainability screen is applied which takes into account environmental, social, and governance 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, to name just a few. The result? A “best in class” selection of bonds issued by companies who have proven their ESG credentials.
Green bonds take a different approach. The proceeds of green bonds are certified as going purely towards eco-friendly projects. Green bond investors therefore have a keen interest in how the money raised by that bond will be used. It’s worth highlighting that all kinds of companies can issue green bonds to finance their own low-carbon transition, from tech companies, to financial institutions, to automakers. Through this ‘use of proceeds’ rule, investors in green bonds can take comfort in knowing they are financing truly ‘green’ activities. We will look into how this works in practice in more detail in a future blog.
Now let’s examine how you could use them in a portfolio.
- 1. ESG corporate bonds
- Traditional investment grade or high yield corporate bonds with an ESG filter
- Core allocation that excludes poorly-rated companies on E, S and G factors
- Potential to reduce risk without creating major biases or performance disconnects from the parent index
Verdict: ESG corporate bonds can be slotted into a portfolio exactly where traditional non-ESG bonds are now. For many investors, that makes credit screened by “best in class” issuers the natural choice to start integrating ESG factors into the investment process. Our research indicates that the extra ESG screen has the potential to improve risk-adjusted returns while being very asset-allocation friendly, as an existing core credit holding can be switched practically like-for-like.
We chose Bloomberg Barclays, a well-known leader in fixed income benchmarks, as the index provider for our sustainable corporate bond range. Furthermore, the ESG screen in our chosen indices harnesses data from MSCI, a global leader in ESG research. Together we believe these two data powerhouses are an ideal match for getting a dependable and sustainable exposure to investment grade and high yield bond markets. Our ESG credit ETFs are also compliant with Article 8 of the EU’s SFDR as they promote environmental or social characteristics.
2. Green bonds
- Make an impact as bond proceeds are guaranteed to be used in pro-climate projects across numerous sectors
- Retain the same characteristics as traditional bonds from the same issuer, such as credit rating
- ‘Use of proceeds’ rule is vetted by the independent Climate Bonds Initiative (CBI), a leader in green bond research
Verdict: Green bonds are a powerful approach to make a direct climate impact within a bond allocation. The ‘use of proceeds’ rule sounds simple, yet it has transformative power to build a better world by mobilising finance towards impactful green projects and assets, the eligibility of which is determined by a strict taxonomy defined by the CBI. To illustrate: in Lyxor’s flagship Green Bond ETF launched in 2017, last year’s three most popular uses for its proceeds were Energy, Green Buildings, and Clean Transport – three crucial components for a more sustainable future.
Our green bond ETF was the first of its kind in the world, and has grown to over €500m in assets. In 2019, it was awarded the Greenfin label, a certification for private investments in a green economy introduced by the French government. Our green bond ETFs are also compliant with Article 9 of the EU’s SFDR as they have a specific sustainable investment objective.
We have more capital available on the planet now than ever before in history. And large slabs of it are in negative or zero interest rate yields. (...) We need to shift that capital into places where it can get some kind of return.And that's going to be green.
Sean Kidney. CEO of the Climate Bonds Initiative
We have the tools – now we must use them
It’s time to be on the right side of change. The day is coming when a company’s fortunes will depend as much on the size of its carbon footprint, the global warming scenario it implies, and its willingness to address broader societal issues, as its ordinary financial metrics.
Whether you want to improve performance, reduce risk, or just invest with a clear conscience, the tremendous advances in ESG data now allow you to do so much more with your bond allocation.
Canadian ice-hockey legend Wayne Gretzky was once asked the secret to his success. He replied: “I skate to where the puck is going to be, not where it has been.” The best investment decisions look to the future. There has never been a better opportunity to skate to where the puck is going – to finance the future with sustainable bonds, get ahead of the curve, and help build a better world.
In the coming weeks, we will take a closer look at these two ways to finance a better future with bonds. If this is a topic that interests you, stay tuned for more.
Our ESG credit ETFs at a glance
Our green bond ETF range at a glance
Did you know?
Most of our ETFs now come with a temperature score, helping you understand the implied temperature rise of your investments, and helping you build a portfolio compatible with a low-warming future for the planet.
To learn more, head to our new COtool, where you can find temperature scores for those equity and corporate bond ETFs for which the data on the underlying indices is sufficient to reliably assign such scores.
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.
