The variety and scope of sustainable bond funds available to fund selectors is set expand considerably over the next five years, according to research by Cerulli Associates.
The vast majority of environmental, social and governance (ESG) fixed income funds at the present time focus on investment grade corporate bonds, the consultancy said.
Eight five percent of investors apply ESG criteria to investment grade corporate bonds, according to Cerulli’s latest European asset allocation report.
However, Cerulli said: “Investors struggle more with sovereign bonds and high-yield debt, where only 21% and 24% respectively apply ESG criteria.”
The high-yield universe does not lend itself as readily to ESG because issuers are far less transparent, which makes it more difficult for managers to conduct ESG research.
“Managers may therefore choose to avoid ESG products in the high yield space, given that the inability to get the information needed to do proper ESG analysis.”
The report noted that applying the same exclusion lists for an investment-grade credit fund to the high-yield universe would mean cutting out a lot more issuers, and significantly reducing the investable universe.
The report found that 50% of European investors said that there were not enough ESG offerings in the fixed income space.
The firm said it was expecting an increase in the number of social and Sustainable Development Goals bonds in the market over the new few years.
“A lot of the ESG labelled funds are quite small, they have recently launched, or they come from niche providers, which means that if you are a large international investor you may not be able to invest in them at all, because you’d quickly be more than 50%,” Cerulli said.
“However, if there is lack of supply, asset managers will also follow. Five years from now, there will be a lot more products out there and the funds that are out there now will have a longer track record.”
Manage downside risk
The report noted that investing in equity ESG funds and bond ESG funds were vastly different as selectors would have more to take into consideration for the bond funds.
It said that by reducing the worst rated ESG companies would allow investors to receive most of the ESG benefits without negatively affecting alpha generation or diversification.
“Incorporating ESG in fixed income differs from integrating it in equities. Sovereign, sub-sovereign, and supranational issuers are fundamentally different from corporate issuers,” the report said.
“The engagement policies are different and fixed-income indices are more difficult to compile because they include multiple bonds per issuer, multiple issuers per corporate family, private companies (on which data is harder to gather), non-corporate entities, covered bonds, and other asset-backed securities.”
Cerulli also noted that when looking for a fixed income ESG fund selectors should also look out for the difference between bond and shareholder rights, the use of bonds in long term liability management by insurance companies and pension funds, and the position of fixed income instruments in the capital structure of a company within different layers such as senior, subordinated debt, or hybrid.
Lack of standardisation
However, Cerulli said that while there was an increase in demand for fixed income ESG funds and expected the number of funds to increase over the next few years, the lack of standardised ESG framework made it difficult for asset managers to decide on the ESG criteria to use in building the funds.
The report said that selectors should look to spend time with the fund managers to help align both party’s definition of ESG was by starting with an exclusion list.