Questions over ‘S’ in ESG bond funds as AUM approaches $450bn in 2021

Members of the fixed income community were quick to defend the sector, arguing not all should be tarred with the same brush. However, they acknowledged there is a long road ahead when it comes to determining the ESG status of the market. 

In August, a Financial Times investigation revealed asset managers’ holdings of government bonds of certain countries such as Belarus. Meanwhile, The Times covered an investigation by SCM Direct which found multiple examples of misleading ESG-labelled bond funds.  

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Prior to these revelations investors had poured $62.5bn into these bonds in the first seven months of 2021, according to Morningstar figures. 

This led AUM in these ETF and open-ended funds to rise 16% in the period to $445.5bn. 

Now there is a question mark over the S of the ESG equation in the funds. 

David Katimbo-Mugwanya, manager of the £336.5m EdenTree Responsible and Sustainable Sterling Bond fund, explained the “social side of the equation is probably where you could say some of the funds are getting a bit unstuck”.

“Having looked at climate issues for so long, the S of the equation, the human rights responsibility, the business ethics, the employment side of the equation – I think is where some of these funds have been challenged more recently.”

Katimbo-Mugwanya noted investors in sterling bond funds may feel like they have nothing to worry about, but because some of these nations issue sterling-denominated paper they could fall within the investable universe.

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EdenTree, however, has an ESG screen which filters through the issuers that can be included in its portfolios. 

One of these is an Oppressive Regimes screen, which is a list based on assessments of Freedom House, Transparency International and the World Economic Forum and includes countries such as China, Russia, Syria and many more. 

It’s hard being green 

One challenge commonly cited by bond investors is they have fewer opportunities for engagement than equity investors and speaking to a government official feels very different to speaking to a company chief executive.

However, Marion Le Morhedec, global head of fixed income at AXA IM, said that does not hold water for her. 

“Whenever we meet with Treasury departments on the government bond side we talk about ESG for about 75% of the meeting,” she said.

Le Morhedec said a bigger issue for her is regulation and standards. Under the current SFDR rules a portfolio can be classified as Article 8 even if not all the underlying investments fulfil the criteria, particularly when it comes to government bonds. 

For government bonds, an asset manager can argue the ranking of a country on indicators such as health and education, while ignoring others.

“I think everybody within the industry is complaining about the lack of clarity that we have,” she explained. 

Le Morhedec said asset managers are having ongoing discussions with lawyers and regulators to gain clarity on the situation. 

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As of the end of July, over 50% of Article 8 funds offered exposure to equity, while 28% offered exposure to fixed income, according to Morningstar. 

Jose Garcia-Zarate, associate director of passive strategies at Morningstar, agreed that “ESG screening of sovereigns remains a work in progress” and is “a minefield”. 

“There is no consensus about how to incorporate ESG analysis of politically sensitive issues,” he said.  

Garcia-Zarate also said it is important to remember that people have different views on tackling ESG. Because of that, what would be a blatant case of greenwashing for some would not be for others.

There is also the issue of cultural biases.  

“Investors in the so-called West will have a natural tendency to judge governments/countries in other geographical/cultural areas under the lens of western values,” Garcia-Zarate said. 

Pure green glory

For investors concerned about the potential murkiness of government bonds, there is an obvious option: green, social and sustainability bonds. 

Government issuers are reacting to the market at a rapid pace. Last Tuesday, Spain launched its first ever green bond, while Britain is poised to sell its first in the week of 20 September and in October, the EU will enter into the environmentally-friendly debt world.

While green bonds have dominated in the past, bonds issued under the social theme are starting to see sharper increases. 

Issuance more than tripled year-on-year, surpassing $146.6bn in H1 of 2021, compared with $36.8bn during H1 of 2020, according to a report from the Climate Bonds Initiative. 

However, Le Morhedec said there is a way to go.

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“Even though the market has been growing, you do not see all the issuers issuing green social and sustainable bonds,” she said. 

“The market has not yet reached the level where we can make the decision to only invest in green, social or sustainable.” 

However, she said the growth in this area of the market is “impressive”. 

“It is probably the biggest development that we have seen within fixed income over the past years,” she concluded. 

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