Expert discuss Corporate bonds & ESG regulation: “The choice of exclusion criteria has an immediate performance effect.”

How can investors rebalance their fixed income portfolios according to environmental and/or social characteristics? In this interview, Dr Veronika Herzberger, Head of Portfolio Management Fixed Income and member of the Quoniam SI Committee, explains what investors should bear in mind and what special features different bond indices have.

The pressure on investors to make their own portfolios more sustainable is growing. How prepared are institutional investors for this?

Sustainability and ESG factors are also becoming increasingly important for bond investors. Many clients want to make their fixed income mandates Article 8-compliant, but they are often unsure what exactly this means for their investment. Very often we hear the question of how a changeover will concretely affect performance. In addition, investors want to know what exactly the regulation entails and whether they are well positioned for the future challenges.

What is your answer to the question about performance? Do investors have to expect a drop in returns?

That depends largely on the investment universe or the investment region. A simple calculation of the exclusions (BVI association concept) on the past performance shows that the effects on the performance in the EUR Investment Grade Corporates universe are negligible. In the US Investment Grade Corporates universe, on the other hand, they are much more noticeable at 12 basis points. And the Global High Yield Index lands in the middle.

What are the exact reasons for the differences in index performance?

In order for a fund to be Article 8-eligible, it must apply a negative list in addition to other criteria. The higher the percentage of excluded securities, the stronger the effect on performance. The performance effect is directly related to the percentage exclusions compared to the respective benchmark, which amount to around 3 percent for EUR investment grade corporates, but over 7 percent for US investment grade corporates.

Impact of exclusions by strategy:
Proportion of exclusionsp.a. Costs
of the exclusion list in bp
Index performance p.a.
EUR Credit Index2.9%– 11,81%
USD Credit Index (EUR hedged)7.2%– 123,27%
Global High Yield Index5.3%– 65,84%
Methodology: Calculation based on the performance of the excluded bonds in the benchmark for the period 31.12.2016 – 31.12.2021; Benchmarks: Markit iBoxx EUR Corporates, Bloomberg Barclays Capital Global Aggregate Corporate USD ex Fin Min Worst Rating (in EUR), ICE BofA Global High Yield BB-B Index (hedged in EUR)
But why does the share of excluded securities vary so much? Which sectors are affected by exclusions?

The three indices we examined have different characteristics with regard to exclusions. In percentage terms, the most exclusions in the euro area relate to tobacco companies (four issuers), accounting for about 1% of the benchmark. Other exclusions are found in the oil and gas, aerospace and defence, and pharmaceutical sectors (one issuer each). In the US dollar area, excluded issuers have a much higher weighting. Over 3.7% of index exclusions are in the aerospace and defence sector (six issuers).

Exclusions in the EUR Credit Index in percent:
Markit iBoxx EUR Corporates2.9%
Tobacco1.0%
Aerospace/Defence0.6%
Oil & Gas0.6%
Pharmaceuticals0.5%
Electronics0.1%
Mining 0.1%
Commercial Services0.0%
Diversified Financial Services0.0%
Source: BVI, Markit iBoxx EUR Corporates
Exclusions in the US Credit Index in percent:
Bloomberg Barclays Capital US Credit Corporate Ex Subordinate Index Euro hedged7.2%
Aerospace/Defence3.7%
Tobacco1.1%
Oil & Gas0.6%
Pipelines0.6%
Electric0.5%
Mining0.3%
Electronics0.2%
Iron/Steel0.1%
Miscellaneous Manufacturing0.1%
Machinery-Construction & Mining0.0%
Shipbuilding0.0%
Computers0.0%
Source: BVI, Bloomberg Barclays Capital Global Aggregate Corporate USD ex Fin Min Worst Rating (in EUR)
Exclusions in Global High Yield in percent:
ICE BofA Global High Yield BB-B Index (hedged in EUR)5.3%
Oil & Gas3.5%
Aerospace/Defence0.6%
Mining0.4%
Pharmaceuticals0.2%
Tobacco0.1%
Chemicals0.1%
Coal0.1%
Electric0.1%
Telecommunications0.1%
Commercial Services0.0%
Computers0.0%
Engineering & Construction0.0%
Forest Products & Paper0.0%
Machinery-Construction & Mining0.0%
Source: BVI, ICE BofA Global High Yield BB-B Index (hedged in EUR)
Compliance with Article 8 is not just about exclusion criteria, but also a broader obligation that often includes integration. What do investors need to consider?

The focus of Article 8 in implementation for most asset managers and clients is on the combination of exclusions, standards-based exclusions, ESG integration and best-in-class. Some clients already want to consider adverse sustainability impacts, the so-called Principal Adverse Impact Indicators, or PAIs for short. In our view, however, it is crucial that the corresponding approach or the Article 8-compliant conversion corresponds to the sustainability strategy and the needs of the investor. The underlying criteria and data must be transparent.

What can the investor expect from Quoniam here? What is the overall approach in your house?

As a data-driven quant manager, we use and integrate a wide range of different data sources on sustainability. We are convinced that the sustainability of an investment can be most credibly achieved through a transparent and objective process that takes into account a variety of high-quality data. But because ratings and metrics in this area vary by data provider, we draw on a variety of sources. We combine ESG ratings, environmental metrics and SDG-related data to create a holistic view of a company or issuer’s sustainability profile. In the end, our main goal is to explain the relevance and differences between the data to our clients and help them make the right decisions from the start.

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