Why ‘ESG’ Bonds Better Than ‘Green’ Bonds

October 06, 2017

Bob SmithSage Advisors, a well-known money manager with some 20 years’ experience in fixed-income investing, has created an ESG-focused (environmental, social, governance) bond index, the Sage ESG Intermediate Credit Index, with Wilshire Associates.

According to the firm, the index, which picks some 110 investment-grade securities from the Barclays Intermediate Credit Bond Index through ESG factors, is designed to mitigate risk and generate better returns over time than a vanilla allocation.

Bob Smith, Sage’s president and chief investment officer, and Ryan O’Malley, portfolio strategist, tell us why ESG in fixed income is important, and how investors can access this strategy.

ETF.com: Let’s talk about ESG and fixed income. Why are you focusing on this theme, and creating an index?

Bob Smith: We have a history of running socially responsible portfolios for a dozen years in fixed income, particularly on the taxable side. The continued interest, and also the growing availability of data that is much deeper and broader in getting into the metrics behind the various components of E [environmental], S [social] and G [governance], was something that attracted us to it. Simply saying no to everything was easy, but how to say yes, and to do it in a way that was beneficial on two levels—the value set, and fundamentally from a financial return perspective—wasn’t easy. Better data helps.

The second motivation was that when you sit and look at the world of funds and ETFs out there, in terms of what socially conscious funds look like, there's startling differences between stocks and bonds.

On the equity side, based on Morningstar's universe, there are roughly 5,130 funds and ETFs out there that have about $11.5 trillion in assets, and only 216 are socially conscious, for about $193 billion. That ends up being about 1.7% of U.S. assets in Morningstar's universe—small, but growing.

On the fixed-income side, there are about 1,660 funds and ETFs with roughly $3.6 trillion. Only 42 are socially conscious, about $17 billion worth. That's less than 0.5% of all assets. There's a need, and there's definitely a gap.

ETF.com: From an investor perspective, what does an ESG focus means in terms of returns in a fixed-income portfolio?

Ryan O’Malley: One of the things you hear about in the equity world is that people engage with the management teams because you’re a shareholder. I’d argue that if you're holding bonds of a company, you have equal—if not greater—opportunity to engage with management.

Secondly, it impacts performance in fixed income. The strategy really tries to pick the best people who are leaders in their peer group, whether that's a communications company or a tech company or a bank or whatever. What you end up getting is a risk mitigation tool.

We've seen empirically from returns that you get about 50 to 60 basis points of positive incremental returns in a conservative fixed-income strategy. That may not be super-exciting to an equity person, but in the fixed-income world, that's pretty exciting.

You also have lower volatility. And you have an upward migration in Moody's and S&P credit ratings over time for the folks who do things the right way. People are always trying to figure out who's going to get upgraded and who's going to get downgraded—so, lower volatility, better credit ratings, better performance.

 

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