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ESG initiatives have established themselves as one of the
fastest growing areas in the investment industry today. Globally,
ESG assets have exceeded $35 trillion, with over half of it focused
on Europe. While the lion's share of these ESG assets is focused on
equity products, fixed income products account for about $3
trillion of them. To supplement this fast-growing market, the
iTraxx MSCI ESG Screened Europe index was launched in 2020 to offer
market participants the ability to gain exposure to, or hedge,
broad European ESG Corporate credit risk.
The iTraxx MSCI ESG Screened Europe index mitigates ESG risks by
screening out names from the highly liquid iTraxx Europe index that
are involved in adult entertainment, alcohol, gambling, weapons,
firearms, tobacco, nuclear power, genetic engineering, and thermal
coal. Firms with significant controversies related to their social
and environmental impact are also excluded, as are firms with an
MSCI ESG Rating of BBB or below. The names that are violators of
the UN Global Compact are not explicitly excluded through a
UNGC-based criterion, however, the current ESG screening criteria
indirectly results in these names also being excluded.
So far, the iTraxx MSCI ESG Screened Europe index has five
market markers actively quoting the index and providing liquidity.
The interest in the index from global banks to provide liquidity
within months of its launch has been a promising start for the
product. Further, there have also been recent issuances of exchange
traded and non-exchange traded structured products such as
credit-linked notes on the back of this index. These products allow
investors to gain physical exposure to European ESG corporate
credit risk. Finally, there is ease of access for the iTraxx MSCI
ESG Screened Europe index as market participants can trade the
index via established Multilateral Trading Facilities (MTFs). The
index is also clearable, making the market for this index more
efficient by enabling market participants to trade it without
counterparty risk.
Index Size trend
Since the iTraxx MSCI ESG Screened Europe index was launched in
June 2020, the general trend of the index size has been upward.
This is due to the increasing number of iTraxx Europe constituents
becoming eligible for the ESG-screened version. While some of these
changes are driven by changes in the composition of the overall
iTraxx Europe index, majority of the changes are due to
improvements in the MSCI ESG ratings of the iTraxx Europe
constituents. The trend is consistent with the increase in the
number of issuers in iBoxx MSCI ESG bond indices as well.
Spread correlation to Main
Despite the increase in index size of the iTraxx MSCI ESG
Screened Europe index from Series 33 to Series 36 as shown in the
previous chart, it is interesting to note that the correlation of
the spreads of the index with those of the overall iTraxx Europe
index has actually decreased. This shows that while the iTraxx MSCI
ESG Screened Europe index may be similar to iTraxx Europe in terms
of index composition, it is still a unique product that provides
distinct diversified credit exposure.
Basis to Main
Relative value trading is a key aspect of the iTraxx MSCI ESG
Screened Europe index. Being an ESG-screened version of the iTraxx
Europe index, trading two indices in tandem with each other
presents a number of arbitrage opportunities. An interesting
observation is that at the time of its launch, the iTraxx MSCI ESG
Screened Europe index was being quoted at about 10 to 12 basis
points tighter than the overall iTraxx Europe index. This basis to
the Main has consistently reduced to about 2 basis points in
November 2021. This decrease in the basis between the two indices
can be partly attributed to the increase in the number of
constituents in the ESG-screened version, causing the index to
trade at similar levels as the overall iTraxx Europe index.
Returns
One of the use cases of the iTraxx MSCI ESG Screened Europe
index that has seen some traction in recent months is the issuance
of ESG credit-linked notes. The index can be used to create
structured products that offer "ESG yields" to investors. While the
returns of the iTraxx MSCI ESG Screened Europe index are lower
relative to that of the iTraxx Europe index, it is interesting to
note that in periods of market downturn, the ESG-screened version
has outperformed the overall iTraxx Europe index. This was observed
during the volatile period last year from September to December
2020 arising from the Brexit negotiations and vaccine developments.
Prior to the index starting trading in June 2020, on a theoretical
basis, the iTraxx MSCI ESG Screened Europe index also outperformed
the overall iTraxx Europe index during the market downturn in March
2020 induced by the Covid-19 pandemic.
Volumes
Despite the regular quoting activity and global market makers
providing liquidity, actual traded volumes of the index have been
modest relative to those of iTraxx Europe. However, the index is
still in its nascent stage and we believe volumes will pick up over
time. The index is still the only standardized credit derivative
that can be used to provide exposure to (or hedge) European ESG
corporate credit risk. Building liquidity in CDS indices is often a
dilemma of causality - new market participants want to see strong
liquidity in the index before they want to begin trading, which
only develops when new market participants start trading the
index.
That being said, the index is a structurally sound product
consisting of liquid index constituents and benefits from
standardized trading conventions and infrastructure. Though growing
at a fast pace, the ESG assets in fixed income are still in their
early stages. As the market matures in the coming years, we believe
the iTraxx MSCI ESG Screened Europe index will be key instrument
that supports this market.
Posted 16 December 2021 by Srichandra Masabathula, Associate Director, Indices, IHS Markit
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May 12
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