Comparative analysis of bond indexes shows potential benefit in using best-in-class screens
As the body of evidence suggesting that investing sustainably doesn’t have to come at the expense of performance grows bigger, new research from Morningstar Indexes indicates that the same applies for the Canadian fixed income space.
“Morningstar is really committed to providing high-quality solutions to the Canadian market,” Katie Binns, senior product manager, Fixed Income & Multi-Assets Indexes at Morningstar, tells Wealth Professional. “This is just one very important tool that we want Canadian investors and advisors to have in their toolkit to help showcase the most sustainable investment practices in Canada.”
In the study, the global index provider compared the performance of the Morningstar Canada Corporate Bond Sustainability Index with that of its parent, the Morningstar Canada Corporate Bond Index. As Binns explained, the daughter benchmark was generated using data from Sustainalytics, which Morningstar acquired in 2020.
The researchers looked at three factors: the ESG risk ratings, the flagship data offering of Sustainalytics that looks at material financial risk linked to ESG issues; controversy scores, which concern controversial issues surrounding a company that may negatively impact it, like the Dieselgate scandal with Volkswagen; and product involvement screens, where issuers with involvement in products that are judged not to be appropriate for an ESG index, like nuclear weapons and civilian firearms, are screened out.
“From there, we factored those elements into 27 buckets on the bond side to order the securities and take the top 50% most sustainable bonds in each bucket,” Binns says. “Those 27 buckets are really the key to ensuring that we come out with very market like performance for the index.”
The end result of that screening and organization process, she says, is a benchmark with significantly lowered ESG risk, alongside performance that's very similar to the market. The best-in-class methodology they used, she added, is fully compatible with Morningstar’s equity offerings, which means investors can take and apply the methodology consistently across asset classes.
Aside from having best-in-class ESG profiles, the Canadian corporate debt portfolio of companies represented in the Morningstar Canada Corporate Bond Sustainability Index returned 5.01% annualized over the past three years, 18 basis points higher than its parent non-ESG index.
“To an equity investor, that 18 basis points of additional outperformance is really nothing,” Binns says. “But to some fixed-income investors, that can be meaningful, and small differences in composition can have a significant impact on performance.”
As far as the research goes, the outperformance of the sustainable corporate-bond index stems from its modestly higher allocation to BBB-rated bonds – 50%, compared to the slightly less than 49% weighting within the Morningstar Canada Corporate Bond Index – as well as somewhat stronger-performing A-rated credit in the sustainability index.
Another important factor was the slightly higher duration of the sustainability portfolio compared to the parent index, which allowed it to benefit from certain movements in the yield curve. In 2019, Binns says the spread between the Canadian 2-year and 10-year was very tight; then when the pandemic arrived, markets went haywire and rates from all tenors plummeted. As the economy recovered, particularly in the latter half of 2021, the yield curve flattened significantly, particularly on the shorter end, which meant bonds on the longer end performed relatively better.
“Of course, these things can change over time,” Binns cautioned. “The index is designed to perform very similarly to the parent. Low tracking error is really the success metric we’re looking at.”
Overall, the study serves as confirmation for advisors and their clients that investing sustainably doesn’t have to mean giving up yield and return. And because the methodology doesn’t exclude any particular industry sectors, it allows the best companies to rise to the top, which helps showcase how investors can shift and align their investments with their values without sacrificing performance.
Looking ahead, Binns says the researchers have many other questions to explore. For example, what would happen if instead of selecting the 50% best-in-class companies from each bucket, they included just the top 25%? What about if they zeroed in on certain ESG screens that are important to investors, like carbon emissions?
“With ESG, the possibilities are endless. And we're really driven by so much investor demand for more and more ESG solutions, especially for fixed income. So we're really excited to continue to progress in in multiple areas of fixed income ESG research.”