By Lee Clements, Head of Applied Sustainable Investment Research, Global Investment Research
Rising bond yields this year have seen many market analysts reach for a famous fixed income quote. James Carville, a White House political advisor, on being told that his government would have to rein in spending, wished that he could be reincarnated as the bond market – “because you can intimidate everybody.”
But fixed income markets are facing one risk that they cannot face down. Not so long ago, many investors saw sustainability or climate issues risks as down the road, but numerous data points show that the future is already here. A material portion of both issuers and investors are now sustainability-focused, it is now firmly part of the list of risks to be considered, alongside rates, inflation, credit etc. and ESG performance can impact investment performance in some markets. If that is not enough, regulators and stakeholders are forcing it to be a key issue for all investors.
Here are a few examples of the arrival of ESG fixed income risks:
- Studies show a direct inverse correlation between sovereign bond performance (evidenced by CDS spreads) and ESG scores . The better a security’s ESG score, the lower its risk of default
- Issuance of sustainable finance bonds, such as green or sustainability-linked bonds, are growing rapidly and are now 9-10% of global debt capital markets proceeds 
- Sustainability issues are having a growing influence on credit ratings. A recent NLP study by ESMA found meaningful ESG considerations in ~50% of the press releases relating to credit rating actions 
- Rising geo-political risk related to the war in Ukraine war has led investors to reconsider governance in issuers (both sovereign and corporate) relating to authoritarian regimes, human rights, etc. 
- The European Central Bank has recently stated that it will apply climate risk measures to its €386bn holding of corporate bonds 
Fixed income markets are not only unable to face down or ignore SI issues, but they are also assimilating sustainability risks into their frameworks more than ever. These risks are firmly on the agenda of regulators worldwide, with the number of sustainable investment policy interventions growing rapidly .
- Stakeholders are demanding holistic sustainable solutions across their portfolios and fixed income is playing catch up. Only 35% of asset owners are implementing sustainability considerations in their fixed income portfolios, compared with 46% in their equity portfolios (and it is much lower outside of the corporate bond sub-asset class)
While research shows the impact climate change could have for future default potential, even at the sovereign level , we’ve now arguably reached a critical mass of focus on sustainability where its impact has become self-sustaining and as fixed income investors manage their rates or credit risk, they now need to consider how it will impact their sustainability/climate risk and vice versa.
With all the activity and pressure behind sustainability in fixed income, then why aren’t we seeing more products, outside of sustainable finance bonds, and why do sustainable equities keep taking the limelight? The short, simple answer, which is a rare thing to find in the world of sustainability, is that building sustainable fixed income products is a difficult thing to do !
Fixed income is, by its nature, a complex asset class. The first challenge is defining the issuer, with many corporates having complex structures of subsidiaries, which can have different jurisdictions and sectors, any of which can issue bonds. Mapping of these entities, which can be more than 1,000 for entities such as large banks, is critical to align with sustainability data for tilting, exclusions  or assessing climate risk. This becomes even more challenging when you throw in private companies, state-owned entities and other asset classes such as sovereign bonds  or securitized bonds . These also require additional sustainability data, e.g., sovereign ESG and climate data, as well as an understanding of combining asset classes.
Fixed income is also relied upon by many investors as the bedrock of their portfolios and as such much attention must be placed on the investment characteristics of sustainable fixed income products. The risk/return characteristics of bonds is very different to equities and as such the impact of sustainability overlays can have different impacts. With the ever-changing universe of bonds (as they are issued and mature), specific characteristics of individual bonds (including rapidly evolving sustainable finance bond categories, such as sustainability-linked bonds) and evolving impact of sustainability data in changing portfolio allocation and it is critical in the creation of sustainable fixed income products that distinct attention is placed changing risk/return characteristics and portfolio concentrations and/or apply additional overlays to mitigate the risks (‘smart sustainability’ strategies). This is particularly true today as high inflation and rising inflation impact all bond portfolios, including sustainable ones .
The required building blocks to build sustainable fixed income indices are:
- A comprehensive family of conventional fixed income indexes;
- A mapping between bonds, issuers and datasets;
- Broad sustainability datasets (for example, climate risk-related, ESG, UN Sustainable Development Goals) across asset classes;
- A sophisticated range of index implementation techniques;
- Smart overlays to tailor custom solutions and adjust sustainability or financial characteristics;
- Analytics to measure the sustainability characteristics of the indexes;
- Rigorous quality control process across the data sources
An example of an innovative application of sustainability in fixed income can be seen in the FTSE EuroBIG ex Sovereigns SDG index. [GP1]
In recent months there have been plenty of examples of bond markets intimidating central banks, economists, and investors. But it seems that sustainable risk is integral to fixed income markets, and that process can only deepen.
 Pricing ESG risk in sovereign credit: an emerging divergence | Federated Hermes Limited (hermes-investment.com); Pricing ESG risk in sovereign credit | Federated Hermes Limited (hermes-investment.com)
 Sustainable finance weathers wider market storm | Refinitiv Perspectives
 Text mining ESG disclosures in rating agency press releases, ESMA, Feb 2022
 How Russia’s war blindsided the world of ESG investing | Reuters
 ECB takes further steps to incorporate climate change into its monetary policy operations (europa.eu)
 ECB set for greener ‘tilt’ in €386bn corporate bond portfolio | Financial Times (ft.com)
 UNPRI regulation database
 Anticipating the climate change risks for sovereign bonds (part 2) | FTSE Russell
 Sustainable investment – not just an equity game | FTSE Russell
 Decarbonising fixed income investment | FTSE Russell
 Enabling global debt investors to align investment choices with values | FTSE Russell
 How to build a climate-adjusted government bond index | FTSE Russell
 Applying ESG Factor to Government Bond Indices | FTSE Russell
 ESG taxonomy for securitized products | FTSE Russell
 [SIFI Rates Blog]
 Investing sustainably with a custom credit index | FTSE Russell
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