DFMs find slim ethical pickings within high yield

A viral Christmas advertising campaign highlighting the link between palm oil products and deforestation of orangutan habitats has captured the attention of ethically-minded consumers, but it also represents an opportunity for ethically-minded investors in an asset class that has lagged when it comes to its environmental, social and governance (ESG) credentials.

While 85% of investors apply ESG criteria to investment grade bonds just 24% apply it to the high yield space, according to research from Cerulli.

A report from the researchers states: “The high-yield universe does not lend itself as readily to ESG because issuers are far less transparent, which makes it more difficult for managers to conduct ESG research.

“Managers may therefore choose to avoid ESG products in the high yield space, given that the inability to get the information needed to do proper ESG analysis could result in an unsatisfactory product, which would damage the manager’s credibility and reputation.”

The M&G (Lux) Global High Yield ESG Bond fund has held Iceland Foods, the supermarket chain behind the advertising campaign, since launch with its in-house sustainable analyst favouring the issuer for its commitment to cut palm oil from own brand products by the end of 2018.

The animated advert (pictured) was meant to raise awareness of Iceland’s environmental push, but instead faces being banned for its links to Greenpeace, which is deemed to be a political group. The decision has prompted a backlash from consumers, which has sent the campaign viral with 5.1 million views on Iceland’s Youtube channel alone.

“This has been very positive from an ESG perspective but it’s also been a great marketing ploy. The advert ban has created a lot of noise plus increased visibility of the issue,” says James Tomlins, who co-manages the fund with Stefan Isaacs. The issuer has also pledged to go plastic-free by 2023.

DFMs look elsewhere for ESG fixed income exposure

Across fixed income, many ESG funds are too small, lack a track record or come from niche providers, according to an institutional investor quoted in the Cerulli report.

There are 10 high-yield strategies that have been tagged as socially-conscious, according to Morningstar Direct. Only four of those offer a sterling share class and most don’t have the more than £150m required by a number of DFMs for investment.

The 7IM Sustainable Balance fund is currently looking to add to allocations in high yield stating a number of ESG products have recently launched in the space.

In the meantime, it invests in RM Secured Direct Lending with portfolio manager Camilla Ritchie stating while it is not strictly high yield it has similar risk-reward dynamics. The investment trust holds healthcare companies, renewable energy and student accommodation sectors, among others and it screens for ESG.

Socially-conscious high yield funds available to UK investors

Source: Morningstar Direct

At Parmenion, the Robeco High Yield Bonds fund is the only product that comes up through its screening process, which requires daily dealing, a sterling share class, plus a certain threshold of assets, which varies according to the asset class. However, the on-platform discretionary fund manager has no strategic allocation to high yield anyway, including in non-ESG strategies.

“At the index level, there is no benefit in investing in more risky securities because you get a lower return and a higher drawdown. I’m not saying there are no fund managers that can identify specific credits among that range where there are better risk-return profiles more in your favour, but we don’t believe in a strategic allocation to the asset class,” says senior investment manager Andrew Gilbert.

Thematics and impact don’t work

There are several ESG methodologies that work in other markets that are difficult to apply to high yield, says Tomlins.

Thematic investing is one example with not enough high yield issuers to create a portfolio around issues like water sustainability or renewables, for example. “You end up with a very concentrated portfolio,” Tomlins says.

Additionally, impact investing is more suitable to project-based debt in the private markets, he argues.

“For a mutual fund with daily liquidity requirements that debt is simply not liquid enough. We have an institutional impact fund but that has fairly limited liquidity needs.”

M&G applies traditional negative screens, such as tobacco, pornography, alcohol and gaming, and has recently added nuclear energy and coal due to client demand. In addition, violators of the UN Global Compact are excluded while a positive tilt requires issuers to hold an MSCI Ratings ESG score above three.

The fund has 10% wriggle room to hold issuers that are not MSCI rated with Iceland being one such example.

A controlled experiment

The M&G strategy is a sister fund to the existing £1.1bn Global High Yield Bond fund, which Tomlins also manages. But the ESG approach has little affect on sector, country or credit rating allocations even though it excludes 31% of the investible universe, he says.

Gaming is the largest exclusion representing 2.4% in the original fund, which launched in 1998. The ESG screens also limits some hard currency emerging markets issues with Brazilian business Petrobras excluded for historical corruption issues.

ESG vs non-ESG performance in M&G high yield strategies 

Source: FE Analytics/data retrieved on 20/11/2018

However, Tomlins says differences between the strategies are at the margin and the team’s investment view can be enacted without bringing bias into the portfolio. Currently, the ESG strategy has underperformed over a one-year period falling 1.74% compared to a 1.29% fall in its sister strategy, according to FE Analytics. However, over more recent periods this trend is reversed.

“What we’ve got here is quite an interesting controlled experiment,” he says, noting over time the two funds will provide statistical support for or against the outperformance of an ESG approach. The team expects the ESG to deliver marginal outperformance over the long term.

Parmenion will look at non-ESG sister strategies for track record if they have the same investment approach, fund managers and investment teams, says Gilbert.

Strategic and corporate bond fund exposure

Parmenion only has indirect high yield exposure via funds like Rathbones Ethical Bond, Edentree Amity Sterling Bond, Liontrust Sustainable Future Corporate Bond, RLAM Ethical Bond and Kames Ethical Corporate Bond.

Except for the Edentree and RLAM funds, which are in the Sterling Strategic Bond sector, they all have a limit of 20% to be allocated to high yield according to the Investment Association requirements on the Sterling Corporate Bond sector. Because of the asset class’s correlation with equities, Parmenion prefers fund managers who can buy into high yield when they see value in individual credits rather than holding a strategic allocation, says Gilbert.

Rathbones Ethical Bond manager Noelle Cazalis highlights the Co-Operative Group’s sustainable bond launched in November as an example of increased ESG issuance, which is growing both within investment grade and high yield. “The broader opportunity set is necessary for the market to develop efficiently,” she says.

The Edentree Amity Sterling Bond fund has a third of its holdings in high yield although fund manager David Katimbo-Mugwanya says he doesn’t aim for any explicit allocation. At the tail end of the credit cycle, Katimbo-Mugwanya says there are risks credit spreads will widen, particularly as monetary policy normalises.

Within investment grade, there are 17 ESG funds that meet Parmenion requirements for its ESG, ethical and sustainable fund ranges with 10 of those having a track record of more than three years, says Gilbert. “Generally, across the ESG fund space it’s all investment grade.”

ESG launches required to meet demand

Despite regarding the current macro environment as unfavourable, Gilbert expects to see ESG high yield product launches.

“There’s been a dramatic rise in demand for ESG and ethical strategies in the UK so I’d expect fund issuance across the whole fixed income space to dramatically increase over the next five years as a result, which might well include high yield bonds but it’s probably going to be at the back end of the priority list.”

ESG data and ratings are now available for most investment-grade credit issuers as well as a large proportion of high-yield issuers, says Cerulli. Ian Horn, credit analyst at Muzinich & Co, says high yield companies are becoming more open to incorporating ESG factors into their business operations.

“Bond investors are increasingly making their views known in management meetings and in primary market roadshows, with ESG topics receiving increasing ‘air-time’. As management teams realise the importance of these topics, there are increasing opportunities for investors to engage with them,” Horn says.

Within the M&G (Lux) Global High Yield ESG Bond fund, a UK university endowment with an income requirement was the first major investor while France has been the source of most retail interest in the fund. Institutional investors in the Nordics are one of the main sources of flows.