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ESGs to enter mainstream CLO market within 5 years: Morgan Stanley

·3 min read
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A new Morgan Stanley (MS) report projected that environmental, social, and corporate government (ESG) concerns will become more central to the collateralized loan obligation (CLO) market by 2026.

The report concludes that ESGs have been a “defining theme” of 2021. “The number of ESG-focused fixed income funds globally has nearly doubled over the past five years from ~630 at end-2016 to ~1,200 currently,” the authors said in the report.

The MS report is the latest research to support the growing sentiment which holds that an ESG revolution is coming to the CLO market. Citigroup (C) projected earlier this year that 20%-40% of U.S. CLO managers will incorporate ESG themes into new issue CLOs in the next two years.

Wall Street has taken a more aggressive interest in ESG investments as of late. Earlier this month JPMorgan (JPM) announced that a greater focus would be placed on investment products with environmental, social and governance themes, and a new ESG was added for derivatives in an effort to promote sustainability.

ESG adoption is still in its infancy within the CLO market, the report notes, as there is a considerable dearth of clarity surrounding ESG guidelines for most companies.

“[A] lack of ESG-related disclosures from private companies and significant manager discretion make it difficult for ESG CLO investors to hold other parties accountable,” the report explained. “No CLOs have yet been issued with thematic exposure or impact investing guidelines.”

Eye on Europe

Europe has dominated ESG investments for the past decade, accounting for more than 70% of the total number of ESG-focused fixed income funds worldwide for 2021 year-to-date. The United States and Asia Pacific, the next two largest regions by number of ESG-focused fixed income funds, each accounted for less than a fourth of Europe’s share.

“At this point, it is clear that CLOs globally are still in the early days of ESG adoption, with the European market more advanced than the U.S. market,” the report noted.

Bullish projections for the future of ESG-focused CLOs are supported by the recent stimulation of ESG interest among consumers and a rise in related inbound calls, the Morgan Stanley report said. “The frequency and tone of conversations around this topic have shifted substantially since the end of last year: inbound calls have gotten both more frequent and more rigorous as market participants across the ecosystem have begun digging in and looking for ways to align investments with ESG objectives.”

ESG conceptual image depicting the connection among its strategies
ESG conceptual image depicting the connection among its strategies

The report breaks ESG products into four categories: negative screening, positive screening, thematic exposure, and impact investing. Negative screening describes the act of managing undesired ESG exposure by phasing out the use of controversial products or sectors, like tobacco, fossil fuels, or opioids. Positive screening allows for investing in all sectors of the market, but only choosing the most sustainable products within each asset class.

Thematic exposure describes a deliberate focus on products which give exposure to specific sustainability themes. The report gives low carbon and affordable housing as examples.

The last category, impact investing, is intended to maximize an investment’s impact. This involves investments with the intent to deliver a measurable positive social or environmental impact.

With these terms, researchers have attempted to give a lens through which ESG involvement can be assessed. Most ESG investments are examples of negative screening, the report found. “While many deals (especially those issued on the European side of the market) include negative screening, only a handful (exclusively on the European side) include positive screening… No CLOs have yet been issued with thematic exposure or impact investing guidelines.”

The report notes that the authors' optimistic, yet realistic view, is that within five years, “a majority of the CLO universe will eventually utilize a mix of negative and positive screening.”

Ihsaan Fanusie is a writer at Yahoo Finance. Follow him on Twitter @IFanusie.

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