What's in a corporate bond ESG fund? | Vanguard Switzerland Professional

Commentary by Fong Yee Chan, head of ESG strategy, Vanguard Europe

Environmental, social and governance (ESG) funds have experienced strong growth in popularity, with a wide variety of funds that can fulfil a number of objectives. These can include mitigating ESG-related risk, removing exposure to activities that do not align with an investor’s values or effecting meaningful change through greater allocation to companies that are making positive changes to society and the environment.

While equity ESG funds have garnered much of the headlines, as well as the flows, awareness is mounting around ESG fixed income funds. Fixed income funds that use an exclusionary screening methodology are one option for ESG-conscious, long-term investors looking to put together balanced, diversified bond portfolios to meet their investment goals.

There are a number of products available in the market, based on differing indices and methodologies. Understanding exactly what’s excluded from a product and why, the investment implications and what this means in a portfolio context are critical to selecting an exclusionary-screened corporate bond fund that meets investors’ investment and ESG goals.

What’s excluded, and why

A key point to consider for investors in exclusionary-based fixed income ESG funds is whether they fully understand the index screening methodology. In other words, which categories of companies and bonds are excluded, and how are the exclusions implemented? Understanding the underlying methodology is important because this dictates the outcomes—both ESG and investment—the product will deliver.

Vanguard’s ESG Global Corporate Bond UCITS ETF* tracks the Bloomberg Barclays MSCI Global Corporate Float-Adjusted Liquid Bond Screened Index. The index includes investment-grade corporate fixed rate bonds from both developed and emerging market issuers denominated in multiple currencies. It is constructed according to the same rules as its parent, non-ESG benchmark (the Bloomberg Barclays Global Corporate Float-Adjusted Bond Index), but with one important distinction: it removes issuers according to certain ESG criteria.

These criteria screen companies based on product and conduct involvement research, removing issuers with ties to activities including non-renewable energy, weapons, genetically modified organisms (GMOs) and vice products. Most of these activities (specifically non-renewable energy, tobacco, weapons and GMOs) are screened according to a 0% revenue threshold. That is, if an issuer derives any revenues from these activities, they are removed from the index.

Activities classed as adult entertainment, alcohol and gambling are subject to a revenue threshold of 5%. This is to help reduce the risk of excluding large, diversified companies which derive a small part of their revenues from vice products, which tend to face less restrictive regulatory constraints than more heavily regulated activities, such as weapons or fossil fuels.

The index also excludes issuers linked to severe controversies. This is a measure of an issuer’s involvement in major ESG controversies and how well they adhere to international norms and principles. These include, but are not limited to, the standards defined by the United Nations Global Compact Principles¹. MSCI ranks ESG controversies on a 0-10 scale, with 0 indicating the “very severe” controversies, which are removed from the index. Issuers without ESG Controversy Scores from MSCI are also excluded. As a result, some well-known names are excluded from the index. For example, aerospace company Boeing and financial services group Wells Fargo & Co appear in the parent index but are both screened out of the ESG index for being linked to severe controversies (Boeing is also excluded for being involved in nuclear, controversial and conventional weapons).

How much is excluded

Investors in ESG-screened bond index products will inevitably gain exposure to a smaller universe than the equivalent unscreened parent index. Depending on the index in question, ESG corporate bond indices can exclude more than half of the bond universe by market capitalisation and over two thirds of the issuers relative to non-ESG benchmarks. This highlights why it’s important for investors to understand the underlying index methodology to ensure it meets the ESG and investment outcomes they are seeking.

For example, the index that Vanguard’s ESG Global Corporate Bond UCITS ETF tracks excludes 48.63%² of the bond market capitalisation of its parent index. It excludes 8,875 of the 14,185 bond issues within the parent index and excludes 1,776 of the parent’s 2,679 issuers. Despite the exclusions, the index offers investors diversified corporate bond exposure, comprising 5,310 bonds issued by 903 different issuers, while mitigating ESG-related risk. This compares favourably with some of the more concentrated ESG-screened global corporate bond indices available in the market, some of which offer exposure to a few hundred constituents.

As a result, the characteristics and performance of screened funds can and do differ from those of non-screened exposures. Looking at the Vanguard ESG Global Corporate Bond UCITS ETF’s index and its non-screened, parent index, while the average quality of the bonds in the screened index is broadly the same as that of the parent, the average yield, coupon, maturity and duration are all slightly different. The sector weightings also differ, with the ESG index comprising a smaller proportion of bonds issued by industrials and utilities, and a larger weighting to those issued by financials, than the parent benchmark.

Index comparison: ESG-screened versus non-ESG screened corporate bond indices

Attributes	Bloomberg Barclays MSCI Global Corporate Float-Adjusted Liquid Bond Screened Index	Bloomberg Barclays Global Aggregate Float- Adjusted Corporate Index
Number of issues	5,310	14,185
Number of issuers (bond tickers)	903	2,679
Market Cap Excluded	48.63%	-
Average YTW	1.39%	1.66%
Average coupon	2.84%	3.18%
Average maturity	9.05 years	9.71 years
Average quality	A3/BAA1	A3/BAA1
Effective duration	7.01 years	7.28 years

Source: Vanguard, Bloomberg Barclays. Data as at 30 April 2021.

Similarly, investors that opt for ESG-screened bond products should be prepared to experience performance that may at times differ from that of equivalent unscreened products.

Given that ESG-screened fixed income indices can exclude half of the underlying bonds or more (in terms of market capitalisation) included in the parent index, it’s perhaps not surprising that there are these deviations in risk and performance characteristics.

However, while Vanguard’s range of ESG ETFs screen out securities that don’t meet their ESG criteria, they are designed to maintain broad diversification at low cost with a risk profile similar to their parent index, all the while mitigating certain ESG-related risks and offering investors greater choice aligned to their values.

How it impacts your portfolio

It’s important to understand the investment implications of a fixed income ESG product and how it can fit in a portfolio, as is the case with any investment product.

For many investors, bonds are a source of stability in a portfolio, and our research suggests that whether investors opt for ESG-screened fixed income products or non-screened exposures, this decision neither adds to nor detracts from the shock-absorbing attributes of bonds.

ESG-screened fixed income products will—by definition—contain fewer underlying securities, and offer less diversification than the equivalent unscreened products. But a broadly diversified ESG-screened fixed income product can nevertheless offer considerable diversification.

Here, considered benchmark selection is key. The ESG-screened bond products available to investors in Europe offer a wide range of methodologies and outcomes. While some offer exposure to thousands of ESG-screened bonds, others seek to replicate a universe of just several hundred.

Some ESG-screened corporate bond products—including Vanguard’s ESG Global Corporate Bond UCITS ETF—also take a liquidity-screened approach, applying higher bond minimum issuance sizes relative to the parent index. This can help to lower transaction costs as well as the total cost of investing while still offering high levels of diversification

Putting it all together

ESG-screened fixed income products will rarely be held in isolation by investors. Another key consideration is how they complement and fit alongside other parts of a portfolio. By adopting the Bloomberg Barclays-MSCI index for its Vanguard ESG Global Corporate Bond UCITS ETF, Vanguard has a consistent index provider across all of its fixed income products. This allows ESG-conscious investors to build low-cost, diversified bond portfolios by combining ESG and non-ESG exposures.

The Vanguard ESG Global Corporate Bond UCITS ETF can also be combined in portfolios with Vanguard’s ESG equity index funds, which apply exclusions that are closely aligned to Vanguard’s approach to exclusionary index investing.

Most importantly, ESG investing should not mean deviating from sound investment principles. ESG is not a reason for investors to pay much higher fees, nor to be encouraged into high-risk strategies. Focusing on keeping costs to a minimum, taking a long-term approach and being diversified apply just as much to ESG as they do to any other type of investment.

*The ESG Global Corporate Bond UCITS ETF promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics. This Fund has been classified as an Article 8 fund pursuant to the requirements of the EU SFDR.

¹ https://www.unglobalcompact.org/what-is-gc/mission/principles

² Source: Vanguard, Bloomberg Barclays. Data as at 30 April 2021.

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