A pioneering index of credit default swaps linked to sustainable companies has struggled to gain traction with investors, with some viewing it as a solution in search of a problem.
Providers IHS Markit and MSCI together announced the new tradeable index in May, tapping into what IHS called “significant interest” from investors for a basket of CDS — wagers on whether a company will default on its debt — linked to businesses that meet certain environmental, social and governance criteria.
At the time, IHS said the basket would allow investors to hedge their exposure to ESG-friendly companies, by buying what is effectively insurance against bond losses.
But data showed very little trading since the index launched in June. The Depository Trust & Clearing Corporation, which tracks CDS market data, has not yet listed any trading volume for the index, which it said indicated that fewer than 10 contracts were outstanding. IHS has declined to give volume data.
“It hasn’t really traded a lot,” said Jasdeep Singh Aneja, head of European macro trading at Goldman Sachs, citing about six trades in the first few weeks. He said the lack of a “gold standard ESG framework” had made it more difficult for investors to use the index.
“I don’t think there’s a burning demand for this,” said Madeleine King, co-head of European credit research at Legal & General Investment Management.
The index looked to capitalise on the rise of ESG investing, which has reshaped debt markets over the past decade. Annual global sales of green bonds, issued to fund environmentally friendly projects, have grown to more than $200bn, and social and sustainability bonds are also on the rise.
In contrast to bonds, CDS provide no funding to the underlying companies that they reference. They can be used both to hedge bonds as well as to speculate on the demise of a company. In 2018, the Vatican decried CDS as unethical instruments that encouraged betting on the “ruin” of others.
The new product, the iTraxx MSCI ESG Screened Europe Index, takes IHS’s main European CDS index, which tracks the swaps of top-rated companies, and removes those involved in sectors such as adult entertainment, gambling and alcohol.
Companies that break international ethics codes such as the UN Global Compact, as well as those MSCI rates below triple B on its ESG scoring system, are also excluded.
While banks such as Barclays, JPMorgan, Deutsche Bank, Goldman Sachs and Bank of America are making markets in the index — with others including Citigroup considering joining — investors, so far, appear to be steering clear.
“I’m not convinced it’s going to be particularly useful,” said Luke Hickmore, investment director at Aberdeen Standard Investment Management, adding that fund managers were more likely to create their own CDS baskets to hedge ESG portfolios.
There is also no global or European standard for ESG evaluations and, while a whole industry of consultants and ratings firms has sprouted up to quantify these risks, a company’s score can vary wildly.
The first iteration of the new ESG CDS index excluded oil majors Shell and BP, for example, but included their French peer Total. Other European companies removed from the index include aerospace company Airbus, drinks maker Diageo and luxury goods company LVMH.
Mr Hickmore said the variety of approaches between providers and asset managers meant the index was “not going to be a particularly efficient hedge if you’re looking to reduce risk”.
Ms King said that LGIM had decided to create its own CDS baskets to hedge its sustainable investment portfolios, using a more nuanced assessment than MSCI. “[We] analyse the companies in a lot of detail with as much ESG data as we can,” she added.
Srichandra Masabathula, indices product specialist at IHS, said the index could still be useful to hedge portfolios that were “not necessarily based on MSCI ESG data only”.
“Firms looking to hedge would have to take a view on whether this fits within their ESG mandate and how their ESG portfolios are constructed,” he added.
MSCI declined to comment.
Some investors also have concerns about how frequently the sustainable criteria are measured in the index. If a company breaches any of the terms, such as breaking labour laws, or if its MSCI ESG rating is downgraded, the firm will be kicked out of the index only in March or September of each year, when the index series is refreshed.
Will Oulton, global head of responsible investing at First State Investments, said he felt uncomfortable with the idea of trading the index as a result.
“It implies that ESG issues are monitored and updated in real time by the underlying lenders,” he said. “When they’re not.”