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Shades of Green in the Bond Market

Environmental, social, and governance integration in bond funds is difficult. ESG-relevant data is often sparse and inconsistent. It also involves trade-offs. ESG integration introduces active risk that may or may not be rewarded. ESG-intentional bond funds navigate these challenges in a variety of ways. Here, I'll examine a sample from the menu of ESG-intentional bond exchange-traded funds to illustrate these issues.

It's Not Easy for Bond Investors to Be Green

Investors aiming to incorporate ESG criteria in fixed-income portfolios face many of the same challenges as equity investors. These issues range from whether ESG risks are better managed via ownership and engagement or through exclusions, to whether ESG is a factor in and of itself.
Perhaps the greatest challenge facing investors wanting to fold ESG criteria into their bond portfolios is the makeup of the bond market itself. As of the first quarter of 2021, U.S. Treasuries accounted for about 40% of market value of the total U.S. bond market, as measured by the Securities Industry and Financial Markets Association. Another 20% of the market comprised securitized bonds issued by Ginnie Mae, Fannie Mae, or Freddie Mac. Consequently, about 60% of the U.S. bond market points back to a single issuer: the United States government. Scoring sovereigns on their ESG performance is a difficult and politically thorny issue. As such, ESG analysis and scoring in the bond market has been focused primarily on corporate issuers. As a result, most bond ETFs that emphasize ESG criteria are limited to applying them to the nonsovereign portions of their portfolios. Within this narrower slice of the bond market, investors face the same challenges as equity investors: a lack of quality, standardized data to reliably measure issuers' ESG risk. But the market is always evolving, as are investors' options within the realm of sustainability-focused bonds and the funds that invest in them. For example, more bonds are being issued for the express purpose of financing ESG-friendly investments. The largest subset of these is known as green bonds.

Green Bonds

The use of proceeds from green bonds is specifically and measurably tied to projects benefiting the environment. According to the International Capital Market Association, these projects might include those aimed at climate change mitigation, climate change adaptation, natural-resource conservation, biodiversity conservation, and pollution prevention and control.
The green bond market has existed for more than a decade, but it was largely dormant until recently. In 2007, the market comprised fewer than 200 bonds with a total market value of just $10 billion, using the ICE Bank of America Green Bond Index (hereafter the Green Bond Index) as a proxy. At the end of July 2021, the index counted 928 bonds as constituents with a total market value of $773 billion.
Corporate bonds are the largest cohort within the Green Bond Index, accounting for half of the market's value. The largest corporate issuer included in the index is Engie SA, a French utilities provider. Quasi-government issuers, such as the European Investment Bank, make up the second-largest cohort, accounting for a third of the market's value. Sovereign issuers are the smallest segment, representing 15% of total market value. That said, the largest issuer in the Green Bond Index is the French government, which accounts for 7% of the market. Indeed, European issuers dominate the market.
Entering August 2021, euro-denominated bonds accounted for 65% of the Green Bond Index, while U.S.-dollar-denominated debt constituted just 20%. Therefore, exposure to the green bond market requires U.S. investors to either draw from a narrow slice of the opportunity set or accept some degree of (or hedge) currency risk. Regardless of how investors approach it, investing in green bonds entails a large amount of active risk, as the green bond market accounted for just 1% of the ICE Global Broad Market Including China Index as of the end of July.
There are currently two ETFs providing exposure to green bonds. VanEck Vectors Green Bond ETF tracks the S&P Green Bond U.S. Dollar Select Index, which includes U.S.-dollar-denominated bonds that are labeled as green bonds and issued by supranational, government, and corporate issuers from around the world. The second, iShares Global Green Bond ETF tracks the Bloomberg Barclays MSCI Global Green Bond Select (USD Hedged) Index, which includes non-U.S.-dollar-denominated bonds.
Exhibit 1 illustrates the difference between these two funds and their relevant Morningstar Category averages. Notably, their exposure to credit risk and interest-rate risk are markedly different. Eschewing non-U.S.-dollar-denominated bonds tilts GRNB heavily toward corporate issuers, resulting in greater exposure to the small contingent of junk-rated issuers that have raised green bonds. BGRN is a better pick for green bond market exposure to the extent that its portfolio is a more accurate reflection of the entirety of that market. This limits active risk and results in less credit risk in particular.
Exhibit 1 shows that both ETFs are odd ducks relative to category peers. While BGRN is more conservative and representative of the green bond market relative to GRNB, the fund still courts a considerable amount of active risk versus its peer group. Investors need to understand that the greenest choices involve a tension between being green and taking on different risks relative to the broad market and close peers.

Dialing Back Active Risk

Green bond ETFs represent the most verdant segment of the bond market, where ESG impact is most immediately measurable and active risk is the highest. At the other extreme there are ESG-intentional ETFs that use the Bloomberg Barclays U.S. Aggregate Bond Index as their touchstone. These funds attempt to mimic the benchmark's contours while incorporating ESG criteria. They exclude corporate issuers engaged in controversial business practices, which tilts their portfolios to issuers that exhibit better ESG practices. However, given that corporate bonds represent the minority of these funds’ portfolios, the scope for ESG incorporation is limited. The bulk of their portfolios is invested in debt that points back to the U.S. government, which isn't filtered through an ESG lens. As such, these funds' active risk is low and their performance should closely mimic the Aggregate Index's.
The Bloomberg Barclays Universal Aggregate Bond Index includes below-investment-grade bonds but is otherwise similar to the Aggregate Index. IShares ESG Advanced Total USD Bond Market ETF tracks an index designed to mirror the Universal Aggregate Index and thus provides investors with greater opportunity to express ESG-related views relative to Aggregate Index ESG funds, given that its parent index sweeps in junk bonds.
Exhibit 2 shows how these funds' portfolios compare with their ESG-agnostic counterparts as well as their category averages. Given they have little room to take active risk, all four strategies are hard to distinguish from their counterparts that set aside ESG considerations.

Credit Portfolios Are Greener

There are currently four broad, investment-grade ESG-intentional ETFs. Each of them mirrors the credit and duration risk profile of their broader investment opportunity sets, mitigating active risk. Nonetheless, these funds court more active risk relative to the ESG-intentional funds tethered to the Aggregate and Universal Aggregate indexes given that their portfolios are invested exclusively in corporate bonds.
Incorporating ESG principles results in noticeable sector tilts. This is evident in Exhibit 3, which features the sector allocations of the four broad investment-grade funds, as well as iShares Broad USD Investment Grade Corporate Bond ETF, a representative ESG-agnostic peer.

Degrees of Difference

By incorporating ESG criteria, sustainable bond funds are guaranteed to be different from their peers that are underpinned by broad benchmarks. Introducing active risk does not guarantee better or worse performance relative to the market--just different performance. The degree of active risk courted by ESG-intentional bond ETFs varies widely. In the burgeoning green bond market, active risk is high. The degree of active risk courted by sustainable funds handcuffed to the Aggregate Index is fairly low. Everything else falls somewhere in between. Investors looking to incorporate ESG criteria into the fixed-income sleeves of their portfolios should be aware of these trade-offs when balancing doing well financially with trying to do something good for the world around them.
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