Environmental, social, and governance investing is taking root in the debt markets, where demand for ESG offerings is outstripping supply, according to consulting firm Cerulli Associates.
The inclusion of ESG factors in fixed income is becoming more widespread, but opportunities for socially responsible investing remain scarce, Cerulli said in a statement Monday on its European research. The firm expects strong demand from intuitional investors in Europe will drive the creation of ESG offerings in fixed income over the next five years.
With a lot of work already done on ESG in the equities market, the next natural step for many investors is to seek socially responsible deals in high-grade bonds, according to the report. ESG has been slower to catch on in bonds partly due to a shortage of sustainability indexes to gauge performance, Cerulli said.
“ESG integration into fixed income is relatively new, so many institutions rely on their asset managers for suggestions,” Ilonka Oudenampsen, a senior analyst for European institutional research at Cerulli, said in the statement.
ESG data and ratings are now available for most investment-grade borrowers, as well as a large proportion of high-yield issuers, according to Oudenampsen. She pointed to the rise of green bonds as well as the emergence of social bonds and fixed-income tied to the United Nations’ sustainable development goals.
Still, ESG investment options in the bond market are too few to meet growing investor interest, according to Cerulli, which said opportunities are in large part limited to corporate debt.
While some managers use exclusion lists for sovereign bonds, Cerulli said it’s more common to overweight “good” countries in their portfolios while underweighting “bad” ones based on an ESG scoring system, according to the report.
Engaging sovereign borrowers isn’t easy, though a group of investors or a very large fixed-income investing firm may find success with small countries that have a lot of debt, the firm said.
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Sixty-six percent of institutional investors in the U.K. think there’s a lack of bond offerings that incorporate ESG in Europe, according to the report. The belief is shared by half of European institutional investors, the report shows.
“Cerulli research shows an increase in demand for ESG in all segments of the fixed-income market,” André Schnurrenberger, the firm’s managing director for Europe, said in the statement. “We expect to see the launch of a variety of new ESG products over the coming years, including in areas less suited to ESG, such as high yield.”
The junk bond market does not lend itself as readily to ESG because high-yield borrowers are far less transparent, making it more difficult for fund managers to conduct ESG research, according to the report.
While 85 percent of investors apply ESG criteria to investment-grade bonds, only 24 percent do so for high-yield bonds, according to Cerulli. The firm found that about 21 percent of investors apply ESG screening to sovereign bonds.
Fund managers should expect to spend “a significant amount of time” gaining insight into their clients’ views on ESG to come up with a suitable solution, Oudenampsen said.