- For investors considering an allocation to ESG USD corporate bond index strategies, it’s important to understand the screening process and resulting exposure.
- The index methodology behind the Vanguard ESG USD Corporate Bond UCITS ETF tilts towards new-economy industries (i.e., communications and technology) and raises credit quality, compared with the parent benchmark.
- The screening process has minimal impact on the yield and duration profile, meaning the income proposition of the ESG exposure is nearly identical to the parent index on both an absolute and risk-adjusted basis.
Fixed income investors are likely familiar with the rationale for investing in USD corporate bonds. Investment-grade corporate bonds can offer a reliable source of income and diversification for an investment portfolio, helping to reduce overall volatility given the stability of the issuers. But can investors find an exposure that meets these goals while also aligning with ESG considerations? We believe the answer is yes and, as we explain below, the profile of an ESG-screened index can even have compelling attributes beyond what we find in the parent index.
Screening and selection for ESG in USD corporates
The Vanguard ESG USD Corporate Bond UCITS ETF, which conforms with Article 81, offers investors a USD corporate bond exposure with an ESG overlay.
The ETF tracks the Bloomberg MSCI USD Corporate Float-Adjusted Liquid Bond Screened Index. This index exposure consists of global corporate bonds denominated in US dollars, and the methodology screens out companies involved in certain business activities, such as the production and sale of alcohol, weapons and fossil fuels (see table below for full list of exclusion categories). This process is known as “exclusionary screening”.
Private placements that are exempt from Securities and Exchange Commission (SEC) registration2 are also not eligible for inclusion in the index, given they lack the transparency of both issuer and owner – unlike publicly traded debt.
The index has a relatively large minimum issue size requirement of $750 million compared with the parent index ($500 million) or comparable strategies, which tend to have minimum requirements of $500 million or less. In addition, the index excludes eurodollar bonds, which are USD-denominated bonds sold outside the US and which tend to have relatively shallow underlying markets and limited trading. Together, these two criteria bolster the liquidity profile of the underlying USD corporate bonds in the exposure.
Finally, the index is float-adjusted, so it excludes USD-denominated investment-grade corporate debt held by the US Federal Reserve. Until resale in public markets, these securities remain inaccessible to investors and thus are excluded.
The table below shows the top 10 exclusions from the screened benchmark relative to the parent index. These exclusions comprise around 4% of the weight of the global USD corporate bond universe, as of end-May 2024.
Top 10 largest ESG and liquidity exclusions of USD corporate bond issuers
Source: Bloomberg, MSCI screening files. Data as of 31 May 2024. X refers to the criteria where the issuer failed in the ESG screening methodology. Top 10 exclusions screened from the Bloomberg Global Aggregate USD Corporate Index, which is the parent index of Bloomberg MSCI USD Corporate Float-Adjusted Liquid Screened Bond Index.
Fundamentals: New-economy tilt raises credit quality, improves tracking
When we screen out such a diverse set of bellwether companies, how does it affect the fundamentals and performance profile of the parent USD corporate bond exposure?
Fossil fuel involvement is the dominant exclusion criteria. Issuers across utilities (natural gas, electric), energy and capital goods feature as the largest industry underweights, with little to no allocation in the ESG exposure (see chart below). Reweighting on a pro rata basis, after the additional screens, means the fossil fuel exclusions tilt the ESG exposure further towards the financials sector, with banks seeing the largest net increase of 14 percentage points (to 38%), more than offsetting any impact the liquidity screen has on private placements and eurodollar bond issues.
We also see a tilt towards communications and technology, two so-called “new-economy” industries which have low indebtedness with capacity to lever up. Of note, US mega tech companies—including members of the “Magnificent 7”3—issue bonds to fund share buybacks, in sharp contrast to funding the heavy capital expenditure needs of large firms from the capital goods, energy and utilities industries. As a result, the ESG screen will reweight Apple, Amazon and Microsoft higher, doubling their combined weight to 4%. The different corporate funding needs illustrate the diversification benefits of the ESG-screened exposure (otherwise dominated by financials).
Banks and new-economy industries as main overweights
Source: Bloomberg. Data as of 31 May 2024. ESG USD Corporates = Bloomberg MSCI USD Corporate Float-Adjusted Liquid Screened Bond Index; USD corporates = Bloomberg Global Aggregate USD Corporate Index. Industries shown are Bloomberg’s BCLASS 3 classifications.
A natural consequence of the overall higher investment-grade credit quality profile is the slightly higher premium at which the ESG exposure’s underlying bonds trade. Given the immaterial impact to the yield (discounted by a few basis points) and to the duration profile, the income proposition is nearly identical to the parent index on both an absolute and risk-adjusted basis.
The implications for investors are that ESG-screened USD corporate bonds have, overall, an improved quality of issuers in the exposure versus the parent (see chart below). For example, the 7% overweight in single A-rated debt underweights borderline investment grade (BBB-rated) debt by the same magnitude, thus mitigating the risk of holding “fallen angels” in a portfolio. Fallen angels, or bonds that lose their investment-grade rating and slip to junk-bond status, increase turnover in the portfolio and create replication challenges for fund managers looking to preserve the ETF’s tight tracking to the benchmark.
High-grade bias after cuts to borderline investment-grade
Source: Bloomberg. Data as of 31 May 2024. ESG USD Corporates = Bloomberg MSCI USD Corporate Float-Adjusted Liquid Screened Bond Index; USD corporates = Bloomberg Global Aggregate USD Corporate Index. Credit ratings shown on are Bloomberg’s Composite Ratings.
For investors seeking ESG-screened corporate bond exposure for their fixed income portfolios, the Vanguard ESG USD Corporate Bond UCITS ETF is a compelling investment solution. The ESG approach of this ETF exposure goes beyond screening out “bad actors”. By embedding liquidity screens, it harnesses higher quality in investment-grade bonds and offers enhanced diversification potential for fixed income portfolios, especially during periods of lingering high inflation and interest rates.
1 Article 8 funds are defined by the Sustainable Finance Disclosure Regulation (SFDR) as those that promote environmental or social characteristics, provided the companies in which the investments are made follow good governance practices.
2 Issued under rule SEC 144A without registration rights.
3 In our context, Magnificent 7 refers to the companies Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla.
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