What's in a corporate bond ESG fund?
Commentary by Fong Yee Chan, head of ESG strategy, Vanguard Europe.
Environmental, social and governance (ESG) funds have experienced strong growth in popularity, with a wide variety of funds that can fulfil a number of objectives. These can include mitigating ESG-related risk, removing exposure to activities that do not align with an investor’s values or effecting meaningful change through greater allocation to companies that are making positive changes to society and the environment.
While equity ESG funds have garnered much of the headlines, as well as the flows, awareness is mounting around ESG fixed income funds. Fixed income funds that use an exclusionary screening methodology are one option for ESG-conscious, long-term investors looking to put together balanced, diversified bond portfolios to meet their investment goals.
There are a number of products available in the market, based on differing indices and methodologies. Understanding exactly what’s excluded from a product and why, the investment implications and what this means in a portfolio context are critical to selecting an exclusionary-screened corporate bond fund that meets investors’ investment and ESG goals.
What’s excluded, and why
A key point to consider for investors in exclusionary-based fixed income ESG funds is whether they fully understand the index screening methodology. In other words, which categories of companies and bonds are excluded, and how are the exclusions implemented? Understanding the underlying methodology is important because this dictates the outcomes—both ESG and investment—the product will deliver.
Vanguard’s ESG Global Corporate Bond UCITS ETF* tracks the Bloomberg Barclays MSCI Global Corporate Float-Adjusted Liquid Bond Screened Index. The index includes investment-grade corporate fixed rate bonds from both developed and emerging market issuers denominated in multiple currencies. It is constructed according to the same rules as its parent, non-ESG benchmark (the Bloomberg Barclays Global Corporate Float-Adjusted Bond Index), but with one important distinction: it removes issuers according to certain ESG criteria.
These criteria screen companies based on product and conduct involvement research, removing issuers with ties to activities including non-renewable energy, weapons, genetically modified organisms (GMOs) and vice products. Most of these activities (specifically non-renewable energy, tobacco, weapons and GMOs) are screened according to a 0% revenue threshold. That is, if an issuer derives any revenues from these activities, they are removed from the index.
Activities classed as adult entertainment, alcohol and gambling are subject to a revenue threshold of 5%. This is to help reduce the risk of excluding large, diversified companies which derive a small part of their revenues from vice products, which tend to face less restrictive regulatory constraints than more heavily regulated activities, such as weapons or fossil fuels.
The index also excludes issuers linked to severe controversies. This is a measure of an issuer’s involvement in major ESG controversies and how well they adhere to international norms and principles. These include, but are not limited to, the standards defined by the United Nations Global Compact Principles1. MSCI ranks ESG controversies on a 0-10 scale, with 0 indicating the “very severe” controversies, which are removed from the index. Issuers without ESG Controversy Scores from MSCI are also excluded. As a result, some well-known names are excluded from the index. For example, aerospace company Boeing and financial services group Wells Fargo & Co appear in the parent index but are both screened out of the ESG index for being linked to severe controversies (Boeing is also excluded for being involved in nuclear, controversial and conventional weapons).
How much is excluded
Investors in ESG-screened bond index products will inevitably gain exposure to a smaller universe than the equivalent unscreened parent index. Depending on the index in question, ESG corporate bond indices can exclude more than half of the bond universe by market capitalisation and over two thirds of the issuers relative to non-ESG benchmarks. This highlights why it’s important for investors to understand the underlying index methodology to ensure it meets the ESG and investment outcomes they are seeking.
For example, the index that Vanguard’s ESG Global Corporate Bond UCITS ETF tracks excludes 48.63%2 of the bond market capitalisation of its parent index. It excludes 8,875 of the 14,185 bond issues within the parent index and excludes 1,776 of the parent’s 2,679 issuers. Despite the exclusions, the index offers investors diversified corporate bond exposure, comprising 5,310 bonds issued by 903 different issuers, while mitigating ESG-related risk. This compares favourably with some of the more concentrated ESG-screened global corporate bond indices available in the market, some of which offer exposure to a few hundred constituents.
As a result, the characteristics and performance of screened funds can and do differ from those of non-screened exposures. Looking at the Vanguard ESG Global Corporate Bond UCITS ETF’s index and its non-screened, parent index, while the average quality of the bonds in the screened index is broadly the same as that of the parent, the average yield, coupon, maturity and duration are all slightly different. The sector weightings also differ, with the ESG index comprising a smaller proportion of bonds issued by industrials and utilities, and a larger weighting to those issued by financials, than the parent benchmark.
Index comparison: ESG-screened versus non-ESG screened corporate bond indices
Bloomberg Barclays MSCI Global Corporate Float-Adjusted Liquid Bond Screened Index
Bloomberg Barclays Global Aggregate Float- Adjusted Corporate Index
Number of issues
Number of issuers
Market Cap Excluded
Source: Vanguard, Bloomberg Barclays. Data as at 30 April 2021.
Similarly, investors that opt for ESG-screened bond products should be prepared to experience performance that may at times differ from that of equivalent unscreened products.
Given that ESG-screened fixed income indices can exclude half of the underlying bonds or more (in terms of market capitalisation) included in the parent index, it’s perhaps not surprising that there are these deviations in risk and performance characteristics.
However, while Vanguard’s range of ESG ETFs screen out securities that don’t meet their ESG criteria, they are designed to maintain broad diversification at low cost with a risk profile similar to their parent index, all the while mitigating certain ESG-related risks and offering investors greater choice aligned to their values.
How it impacts your portfolio
It’s important to understand the investment implications of a fixed income ESG product and how it can fit in a portfolio, as is the case with any investment product.
For many investors, bonds are a source of stability in a portfolio, and our research suggests that whether investors opt for ESG-screened fixed income products or non-screened exposures, this decision neither adds to nor detracts from the shock-absorbing attributes of bonds.
ESG-screened fixed income products will—by definition—contain fewer underlying securities, and offer less diversification than the equivalent unscreened products. But a broadly diversified ESG-screened fixed income product can nevertheless offer considerable diversification.
Here, considered benchmark selection is key. The ESG-screened bond products available to investors in Europe offer a wide range of methodologies and outcomes. While some offer exposure to thousands of ESG-screened bonds, others seek to replicate a universe of just several hundred.
Some ESG-screened corporate bond products—including Vanguard’s ESG Global Corporate Bond UCITS ETF—also take a liquidity-screened approach, applying higher bond minimum issuance sizes relative to the parent index. This can help to lower transaction costs as well as the total cost of investing while still offering high levels of diversification
Putting it all together
ESG-screened fixed income products will rarely be held in isolation by investors. Another key consideration is how they complement and fit alongside other parts of a portfolio. By adopting the Bloomberg Barclays-MSCI index for its Vanguard ESG Global Corporate Bond UCITS ETF, Vanguard has a consistent index provider across all of its fixed income products. This allows ESG-conscious investors to build low-cost, diversified bond portfolios by combining ESG and non-ESG exposures.
The Vanguard ESG Global Corporate Bond UCITS ETF can also be combined in portfolios with Vanguard’s ESG equity index funds, which apply exclusions that are closely aligned to Vanguard’s approach to exclusionary index investing.
Most importantly, ESG investing should not mean deviating from sound investment principles. ESG is not a reason for investors to pay much higher fees, nor to be encouraged into high-risk strategies. Focusing on keeping costs to a minimum, taking a long-term approach and being diversified apply just as much to ESG as they do to any other type of investment.
*The ESG Global Corporate Bond UCITS ETF promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics. This Fund has been classified as an Article 8 fund pursuant to the requirements of the EU SFDR.
2 Source: Vanguard, Bloomberg Barclays. Data as at 30 April 2021.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Investments in smaller companies may be more volatile than investments in well-established blue chip companies.
ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid-offer spread which should be considered fully before investing.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments.
The funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.
For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com.
This is an advertising document. For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.
The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of shares and /or units of, and the receipt of distribution from any investment.
Vanguard Funds plc has been authorised by the Central Bank of Ireland as a UCITS and has been registered for public distribution in certain EEA countries and the UK. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisers on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.
The Manager of Vanguard Funds plc is Vanguard Group (Ireland) Limited. Vanguard Asset Management, Limited is a distributor for Vanguard Funds plc.
For further information on the fund's investment policies, please refer to the Key Investor Information Document (“KIIDs”). The KIID for this fund is available in local languages, alongside the prospectus via Vanguard’s website https://global.vanguard.com/.
The Indicative Net Asset Value (“iNAV”) for Vanguard’s ETFs is published on Bloomberg or Reuters. Refer to the Portfolio Holdings Policy at https://global.vanguard.com/portal/site/portal/ucits-documentation for holdings information.
The ESG Global Corporate Bond UCITS ETF promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics. This Fund has been classified as an Article 8 fund pursuant to the requirements of the EU SFDR.
Vanguard Group (Ireland) Limited has implemented the EU Sustainable Finance Disclosure Regulation (EU) 2019/2088 (“EU SFDR”), as appropriate. Vanguard has introduced an internal product classification framework that helps to identify whether certain Vanguard funds promote, among other characteristics, environmental and/or social characteristics, or whether a fund has sustainable investment as its objective. Vanguard also considers the degree to which sustainability risks are integrated into the investment decision making process. Statements explaining Vanguard’s approach to the integration of sustainability risk, including into its remuneration policy and a transition statement to support the consideration of Principal Adverse Indicators (this is the impact of its investment decisions on sustainability factors, commonly referred to PAI), will be available on the policy page of Vanguard’s global website.
For Dutch investors only: The fund(s) referred to in this document are listed in the AFM register as defined in section 1:107 Dutch Financial Supervision Act (Wet op het financieel toezicht).For details of the Risk indicator for each fund listed in this document, please see the fact sheet(s) which are available from Vanguard via our website https://www.vanguard.nl/portal/instl/nl/en/product.html.
For Swiss professional investors: The Manager of Vanguard Funds plc is Vanguard Group (Ireland) Limited. Vanguard Investments Switzerland GmbH is a financial services provider, providing services in the form of purchase and sales according to Art. 3 (c)(1) FinSA. Vanguard Investments Switzerland GmbH will not perform any appropriateness or suitability assessment. Furthermore, Vanguard Investments Switzerland GmbH does not provide any services in the form of . Vanguard Funds plc has been authorised by the Central Bank of Ireland as a UCITS. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisors on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.
Vanguard Funds plc has been approved for offer in Switzerland by the Swiss Financial Market Supervisory Authority (FINMA). The information provided herein does not constitute an offer of Vanguard Funds plc in Switzerland pursuant to FinSA and its implementing ordinance. This is solely an advertisement pursuant to FinSA and its implementing ordinance for Vanguard Funds plc. The Representative and the Paying Agent in Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich. Copies of the Articles of Incorporation, KIID, Prospectus, Declaration of Trust, By-Laws, Annual Report and Semiannual Report for these funds can be obtained free of charge from the Swiss Representative or from Vanguard Investments Switzerland GmbH via our website https://global.vanguard.com/
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. BARCLAYS® is a trademark and service mark of Barclays Bank Plc, used under license. Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited ("BISL") (collectively, "Bloomberg"), or Bloomberg's licensors own all proprietary rights in the Bloomberg Barclays Indices. The products are not sponsored, endorsed, issued, sold or promoted by “Bloomberg or Barclays”. Bloomberg and Barclays make no representation or warranty, express or implied, to the owners or purchasers of the products or any member of the public regarding the advisability of investing in securities generally or in the products particularly or the ability of the Bloomberg Barclays Indices to track general bond market performance. Neither Bloomberg nor Barclays has passed on the legality or suitability of the products with respect to any person or entity. Bloomberg’s only relationship to Vanguard and the products are the licensing of the Bloomberg Barclays Indices which are determined, composed and calculated by BISL without regard to Vanguard or the products or any owners or purchasers of the products. Bloomberg has no obligation to take the needs of the products or the owners of the products into consideration in determining, composing or calculating the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays is responsible for and has not participated in the determination of the timing of, prices at, or quantities of the products to be issued. Neither Bloomberg nor Barclays has any obligation or liability in connection with the administration, marketing or trading of the products.
Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.
Issued in Switzerland by Vanguard Investments Switzerland GmbH.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2021 Vanguard Group (Ireland) Limited. All rights reserved.
© 2021 Vanguard Investments Switzerland GmbH. All rights reserved.
© 2021 Vanguard Asset Management, Limited. All rights reserved.