ESG for Bond Funds

Tens of billions of dollars are flowing into Environmental, Social and Governance (ESG)-focused funds. And it’s not just stocks; the fixed income world, too, has seen a surge in interest in applying ESG principles to analyzing and investing in various types of debt.

As with stocks, ESG bond selection typically incorporates a broad range of concerns. Factors include greenhouse gas emissions and climate change, renewable energy, social issues relating to human rights and workplace conditions, and governance matters like business ethics and diversity, among others.

ESG or not, analyzing credit quality is critical in selecting bonds for inclusion in a fund. To that end, active management can add value by identifying those risks that can be mitigated and managed – and in particular, the subset of risks related to environmental, social and governance issues. Accounting for these factors in active credit analysis can help identify concerns that don’t show up in financials and provide a clearer picture of a bond’s risk/return profile.

Core Plus (plus ESG)

Core plus bond funds comprise the second largest investment category in taxable fixed income and are designed to generate potential income as well as capital appreciation while appropriately allocating risk. It is, in our view, a great vehicle for executing an ESG bond strategy – and doing so with active management.

The IQ MacKay ESG Core Plus Bond ETF (ESGB), the newest addition to the IndexIQ ETF lineup, is an actively managed bond ETF that uses ESG investment criteria developed by MacKay Shields, an affiliated boutique of New York Life Investments with $158 billion in assets under management (AUM) as of 3/31/21 and decades of experience in fixed income.

With ESGB, MacKay’s research team combines fundamental bottom-up research and top-down macroeconomic analysis with a robust ESG inclusion process. The focus is on generating risk-adjusted returns by eliminating what is believed to be uncompensated, or under-compensated risks. When ESG risks are elevated, the team excludes the investment from consideration, regardless of price. When ESG trends are improving, further analysis is conducted to determine if investment is warranted. The decision to invest or not is then predicated on relative value considerations.

Active is critical

Active management is critical with ETFs that purport to bring an ESG approach to fixed income investing, because the risks with ESG bonds are not always obvious. For example, in a comprehensive in-depth analysis like MacKay’s, a solar company that meets the “E” criteria in a credit research process, may not meet the “G”, and could fail to be included into the fund for governance issues – something that may have been missed with a passive rules-based strategy.

ESG-focused investing is growing, and these strategies should continue to attract assets as investors increasingly recognize the potential for a positive impact on returns. ESGB provides the opportunity to participate through a broadly diversified portfolio of bonds, with the additional benefits inherent in the ETF structure combined with disciplined, engaged active management.

Related: The Case for Combining Fallen Angels and Low Volatility High Yield