ESG-Enhanced Corporate Bond Indices: A Strategic Allocation
Corporate bonds selected on the basis of both ESG integration and exclusion at the issuer level can replace vanilla corporate bonds — this approach has historically reduced portfolio risk. From our analysis, we can see that ESG-enhanced corporate bonds have consistently tilted towards higher credit quality investment grade bonds.
In this paper, we examine how to incorporate ESG-enhanced corporate bonds into an investment portfolio from a strategic asset allocation standpoint. To this end, we examine the differences between ESG-enhanced corporate bond indices, namely the Bloomberg SASB US Corporate ESG Ex-Controversies Select Index and the Bloomberg SASB Euro Corporate ESG Ex- Controversies Select Index, and their traditional market-value weighted counterparts.
As a reminder, the Bloomberg SASB Corporate ESG Ex-Controversies Select indices utilise both an ESG exclusion1 and integration approach and are designed to target bonds whose issuers have an enhanced ESG profile while keeping in check their active risk to the market value-weighted corporate bond indices.
How to Incorporate ESG-Enhanced Corporate Bonds in a Portfolio Context
ESG-enhanced corporate bonds can form part of a strategic (core) allocation within investment portfolios. Compared to broad-based corporate bond indices, bond indices with a focus on issuers with a strong ESG profile are often less volatile by virtue of their tilt towards higher grade bonds. In turn, this can improve the overall risk-return efficiency of investment portfolios. Along with a reduction in volatility, the inclusion of bonds whose issuers have an enhanced ESG profile undoubtedly improves the ESG profile of the portfolios too.
1There are specified thresholds on when a bond issuer is excluded. For civilian firearms manufacturers, companies deriving 5% or more of their revenues from the manufacture and/or sale of assault and non-assault weapons to civilian customers and/or their key components as well as from the distribution and/or retail sale of assault and/or non-assault weapons. For thermal coal extraction companies, all companies deriving 5% or more of their revenue from the extraction of thermal coal. Finally, for tobacco companies, all companies deriving 5% or more of their revenue from the production or supply of tobacco or tobacco related products and services or 10% or more of their revenues from the distribution and retail sale of tobacco products.
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