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3 ESG Fixed-Income Funds to Keep an Eye On

Here are some interesting strategies from the latest Morningstar Prospects report.

Morningstar Prospects is a list of investment strategies that are not currently covered by Morningstar's manager research analysts but might be in the future. The list provides advance notice of some promising funds that you might want to put on your watchlist.

Prospect strategies remain on the list until the analyst team is comfortable assigning a Morningstar Analyst Rating. Alternatively, they sometimes drop from the list if there are negative fundamental changes, such as investment team turnover or a material change to the investment process, or if investor interest isn't strong enough.

The recently published December 2019 list, which is available to subscribers of Morningstar Direct, featured 46 investment strategies across asset classes and vehicle types, including exchange-traded funds and a separate account. Morningstar Prospects added 11 strategies, including four with explicit environmental, social, and governance approaches, graduated eight to full coverage, and dropped one since the previous publication in July 2019.

Below we highlight three ESG fixed-income strategies of interest from the Prospects report.

TIAA-CREF Green Bond TGRNX Launched in November 2018, TIAA-CREF Green Bond is one of the more interesting ESG offerings available to investors. Rather than simply screening on ESG criteria or considering those factors during the usual investment process, this fund focuses on investments that have a direct ESG impact, such as renewable energy, the redevelopment of contaminated sites, and sustainable building projects. These investments may carry the official "green bond" label, or they may be considered equivalent based on the firm's own assessment. This investment approach is also used with a portion of the assets in TIAA-CREF Social Choice Bond TSBIX, which has a Morningstar Analyst Rating of Bronze. Stephen Liberatore manages both funds; he is Nuveen's lead portfolio manager for fixed-income ESG investing, and he is supported by one of the most robust ESG teams in the industry, along with the firm's large and experienced fixed-income team.

The sole focus on green bonds and other impact investments may result in a narrower opportunity set and possibly divergent returns, but the strength of the management team and its success running TIAA-CREF Social Choice Bond suggest that this is one fund that ESG investors should keep an eye on.

iShares ESG U.S. Aggregate Bond ETF EAGG IShares ESG U.S. Aggregate Bond ETF is a solid core-bond holding for ESG-minded investors. This low-cost index fund looks a lot like the Bloomberg Barclays U.S. Aggregate Bond Index. That's by design. It tracks the Bloomberg Barclays MSCI US Aggregate ESG Focus Index, which matches its sector weightings to that benchmark and only applies an ESG adjustment to the corporate-bond sector, and here the adjustment is modest. The fund removes corporate-bond issuers with the lowest ESG scores from the eligible universe and uses an optimizer to tilt toward the highest-scoring issuers remaining. However, these adjustments must not take the fund's expected tracking error relative to the Aggregate Index above 10 basis points per year, which limits the magnitude of this tilt, keeping it from just owning bonds from the highest-ranking issuers.

The resulting portfolio has credit and interest-rate risk that are very similar to the Aggregate Index. As a result, its performance should mirror that bogy, which it has done since it launched in October 2018. However, the fund's ESG adjustment will likely increase turnover and may cause it to overweight smaller corporate-bond issues, which can modestly increase transaction costs.

The ESG scores that this fund uses are based on MSCI's assessment of each issuer's ESG practices relative to industry peers.

Pimco Total Return ESG PTSAX In recent years, more asset managers have started to offer strategies geared toward investors concerned about ESG issues, and Pimco is no exception. As part of the firm's effort to formalize its ESG platform beginning in January 2017, it renamed this fund Pimco Total Return ESG and altered its mandate.

The strategy already excluded issuers involved in certain industries--such as alcohol, tobacco, military equipment, and gambling--as well as those doing business with Sudan. Starting in 2017, Pimco began to give ESG factors a central role in the fund's credit selection process. In addition to its pre-existing investment restrictions, the strategy now tries to avoid issuers with deteriorating-to-poor ESG practices, such as harmful environmental policies, while emphasizing those with improving-to-exemplary ESG practices. Pimco has hired several ESG specialists in recent years to work on issuer engagement and fine-tune its credit analysts' ESG scoring methodology. That methodology is already well established for corporate and sovereign issuers, and Pimco has begun adapting it to the structured credit and municipal-bond sectors.

In 2018, Scott Mather--CIO of U.S. core strategies and this fund's lead manager--took on oversight of Pimco's ESG portfolio integration process in the United States. While there's still more work to do here, this ESG-focused fund builds on the same strong foundation underlying its Gold-rated sibling, Pimco Total Return PTTRX.

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