Sustainable investing: Making an impact at the front end

Sponsored article: Dan Farrell examines the advantages of sustainability in fixed income

Sustainable investing and bond portfolios make for a good marriage since risk is a focus of both. Bonds issued by companies with favorable ESG ratings tend to trade at tighter credit spreads and offer downside mitigation during periods of market turbulence.

While keeping ESG in mind, it is important to still focus on the primary drivers of fixed income returns such as key rate duration, sector, issuer and option adjusted spread.

We believe thoughtful incorporation of ESG metrics into the investment process provides a holistic approach to portfolio construction. High-rated ESG issuers tend to have larger capital structures, longer durations and tighter spreads, despite no statistical relationship with credit ratings.

Integration of ESG factors into the investment process may provide additional downside mitigation and improve risk-adjusted returns, further bolstering fixed income as a risk asset control while also having a positive impact. It does not need to be an “either/or” proposition.

“E” and “S” don’t have to be neglected

Integrating ESG at the front end of the curve can be complex, especially within money market funds. Investment parameters, market dynamics and instruments reduce the investment universe and typically result in a high concentration in financial issuers.

Implementing negative screens on money market funds is impactful
on the “G” of ESG, but often neglects the E and S. For a more impactful solution investors may wish to consider an ultra short strategy.

The following material is directed to eligible counterparties and professional clients only and should not be relied upon by retail clients

The investment objective of The Northern Trust Sterling Conservative Ultra Short ESG Fund is to outperform money market funds on a total return basis by taking modest duration and credit risk.

This strategy is able to invest in securities outside the traditional money fund opportunity set allowing for a wider sector diversification in corporate bonds.

Broader sector diversification doesn’t only benefit risk, but also allows for a more impactful ESG solution. As the market is expecting the bank rate to remain near zero for a number of years, we consider short term bonds look well positioned to perform.

Investors seeking highly liquid instruments that provide the potential for higher yields than bank deposits, call accounts or money market funds may stand to benefit from investing in ultra short strategies

Our approach

At Northern Trust Asset Management our Sterling Conservative Ultra Short ESG Fund adopts a two-pillar ESG approach. Our process begins by incorporating negative screens to our investible universe based upon our proprietary Northern Trust Custom ESG screens.

These exclude companies that are involved with tobacco, thermal coal, controversial and conventional weapons, civilian firearms and those that violate the UN Global Compact principles.

The second pillar is integration into the investment process. Companies are evaluated and selected based on ESG practices and their ESG profile. Further, once investment is made, companies are compared against peers.

We actively tilt these strategies to overweight ESG leaders or companies with improving ESG ratings, and underweighting ESG laggards and companies with deteriorating ESG ratings*. This approach is executed while keeping credit, duration, country, issuer and sector controlled.

Conclusion

Sustainable investing in fixed income is expanding and short duration allocations do not need to be left behind.

By constructing a high-quality portfolio through an investment process that emphasizes thorough credit research, broad sector diversification, ultra short strategies can target total gross returns of 20-60bps above money market funds (based upon historical index data) while integrating an ESG strategy that is impactful to long-term change and improving risk mitigation.

Dan Farrell is director international short duration at Northern Trust Asset Management.