Dewi John: Has the tide turned against ethical bonds?

Over the first half of 2022, ESG equity, bond and mixed-assets funds resisted the negative flows that have beset their conventional peers. A waning tide will eventually see all boats lower, however – and that is what we have seen in the third quarter, as flows went negative for ESG equities and bonds, with only mixed assets managing to keep a toehold in positive territory.

For equities, this seems to be less down to any disenchantment with ESG per se, but rather a function of investors withdrawing money from the asset class in general. Fixed income flows tell a different story, though – while ESG bonds took in £1.2bn over three quarters, that turns to -£1.3bn over the third quarter. That figures also mirrors the inflows of £1.3bn for conventional bond funds over the quarter.

Duration risk

What, then, is happening in the fixed income market? The structure of the sustainable market is likely not working in its favour. As FTSE Russell Global Investment Research has pointed out: “Many of the areas of sustainable fixed income have heightened exposure to interest rate risk, with lower yields and longer maturities, leading to higher duration risk.” The higher a bond’s duration, of course, the greater its capital loss for any given increase in rates.

This is well illustrated in the following chart, which compares the performance and duration of the FTSE Climate Risk Adjusted World Government Bond Index (Climate WGBI) to the World Government Bond Index (WGBI). The Climate WGBI has a higher weight in European and a lower weight in US sovereign bonds relative to the WGBI. That said, the European sovereigns also have lower interest rates and longer maturity debt than those of the US.

Key sustainable industries, such as wind and solar plants, might also be expected to be issuers of longer-dated debt, as their financing costs are very much front-loaded, in the building of these utilities. An actively managed fund (the majority), however, is not a mirror image of a market – thus, while the universe of fixed income securities a sustainable bond fund can invest may in aggregate be of longer duration, that is not necessarily the case for the individual funds, as the manager can chose to hunker down in the shorter-dated section of the investable universe.

Drilling down

If we take all bond mutual funds and ETFs available in the UK, then we do get something of a different picture than the two like-for-like indices above. As Table 1 shws, over the first 10 months of the year, ethical bond funds are ahead by 78 basis points (bps). While they deliver a lower 12-month yield, they also have a lower duration, whether modified or effective – where the latter allows for cases when the bond has an embedded option or callable bond.

This, however, is a perspective so broad-brush you could paint the M25 with it, without having to go back and forth along the lanes. There are other factors not captured here that will impact performance – plus the differing distribution of ethical bond funds through the numerous fixed income classifications could also distort results. It does have the advantage of a large sample size but needs to be taken with a pinch of salt – albeit one possibly large enough to cause arterial damage.

Table 1: ESG versus conventional bond fund performance, duration and yield

Source: Refinitiv Lipper. Note: All periods from 31/10/21 to 31/10/22

Narrowing focus, Table 2 below compares sustainable and conventional bond funds in three Lipper Global Classifications: Bond Global GBP, Bond Global USD and Bond USD. The classifications are broad and there’s a good number of ethical funds in each, making the comparison reasonably robust. It is a narrower brush – so you would have to drag it along each lane separately in your Sisyphean task of painting London’s blighted orbital – but, again, the metrics drawn upon are limited.

Table 2: Bond Global (USD & GBP) and Bond USD fund performance, duration and yield

Source: Refinitiv Lipper. Note: All periods from 31/10/21 to 31/10/22

What this does tell us, however, is the negative flows in ESG bond funds are not simply a recoil from either underperformance or greater duration risk. Conventional global bond funds – both GBP and USD – have outperformed their ESG equivalents over the first 10 months of the year, despite having a longer effective duration. That said, Bond USD ESG has outperformed its conventional peer. There is, therefore, no clear case for investors rotating from ESG to conventional bond funds because of performance.

Redeeming features

Looking closer at just where this money has been pulled from, 15 share classes of ESG bond funds saw redemptions of more than £100m over the third quarter. Taken together, these redemptions total £2.8bn. They are spread across nine Lipper fund classifications, but the largest quanta have come out of Absolute Return Bond GBP and USD vehicles (-£1bn) and Bond Other (-£516m), where the latter have a bias to mortgage-backed securities and asset-backed securities – from which we have noted significant outflows over the course of the year, whether ethical or not. Given the trajectory of the mortgage market, that should surprise no-one.

What can we make of the £1.3bn outflows from ESG bond funds? It is certainly not chasing performance. One could make the argument investors have pulled money from ESG fixed income, as they believe it has higher duration risk than its conventional equivalent (whatever the reality), or that these funds have fallen victim to the growing scepticism around ESG. Still, that would be pretty tenuous.

Another possibility is that bond ESG funds are ‘collateral damage’ to another large-scale market trend: the shift from active to passive in fixed income, with September alone seeing £6.8bn of redemptions from active bond funds, as passives took £2.1bn. As of October, passive bond funds have £56.2bn of assets under management, only £6.1bn of which is in ESG vehicles (10.9%). For active funds, those figures are £271.4bn and £84.1bn, respectively (31%). Of the nearly 2,400 primary bond fund share classes available to UK investors, only 124 are passive ethical funds, as defined by Lipper.

If there is a likely explanation as to why we have seen bond ESG go into redemption mode, it is that these strategies have been a victim of the dearth of ethical fixed income passive funds, which represents an opportunity for those able to address the demand.

Dewi John is head of research UK & Ireland at Refinitiv Lipper