New Opportunities in ESG CDS Trading

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Stockholm (NordSIP) – On Monday, June 22nd, IHS Markit will make its iTraxx MSCI ESG Screened Europe Index available for trading. Launched in March 2020, this European corporate ESG CDS index is the first of its kind and creates a range new of investment opportunities. It is constructed by applying exclusions onto the iTraxx Europe Index series and screening out companies that do not meet its sustainable criteria.

Exclusion Criteria

The CDS index applies three levels of exclusions, based on controversies, industries and ESG ratings. Companies failing to comply with international norms and principles such as the UN Global Compact and ILO Core Conventions are considered to be facing controversies. The index excludes any companies with a score of 0 on the MSCI ESG Controversy score, which scores companies on a scale of 0-10 with 0 being the entities involved in most severe controversies.

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On an industry level, the fund also excludes specific activities it considers to be inconsistent with certain values associated with responsible and sustainable investment. Companies involved in adult entertainment, weapons (be it civilian firearms, conventional, nuclear or controversial weapons), genetic engineering, tobacco, alcohol, nuclear power, thermal coal and gambling are excluded from the index.

Pure ESG-screens rely on the MSCI ESG Ratings. The iTraxx MSCI ESG Screened Europe index excludes entities with MSCI ESG Rating of BBB and below.

Market Implications

The index provider highlights two potential uses for the ESG CDS index. Naturally, the index provides exposure to and a hedge against broad ESG trends. According to IHS Markit, the index’ similarity to the iBoxx bond indices also allow it to potentially be “an effective hedging instrument to bond portfolios tracking forthcoming iBoxx MSCI ESG indices.”

On the issue of liquidity, IHS Markit notes that “the similarities and high correlation of the index with the overall iTraxx Europe index allows sell-side trading counterparties to use the iTraxx Europe index to hedge their protection buyer positions.”

Andrew Eve, Associate Investment Specialist, Fixed Income at M&G

Looking ahead to the new trading opportunities, M&G Investments’ Andrew Eve dug deeper into the possibilities created by the new instrument. He noted that the new index creates opportunities in relative value trading, the ability to trade a synthetic “non-ESG” index, transparency and ESG profile-raising. Discussing relative value trading opportunities on the asset manager’s Bond Vigilantes blog, Eve noted that new index will increase traders’ ability to exploit divergences between derivatives and the physical securities they reference, and also between the index and individual swaps.

According to the M&G analyst, the new instrument also allows investors to trade between the ESG CDS index and the Main index and “to modulate their exposure to the issuers excluded by the three-step screen.” Such a trade would be useful during times of market stress against ESG laggard names they own.

Relevance for the Nordics

Robert Heaney, Head of Nordics at M&G Investments

“The launch of the ESG index has a wider implication for all investors. Without a structure against which to consider E, S and G factors, the concept can seem quite esoteric and is hard to quantify,” Robert Heaney, Head of Nordics at M&G Investments, told us. “The new index will give credit market participants better access to ESG information and, importantly, better ability to act based upon it, making ESG a more important factor for all to consider.”

According to IHS Markit, the index will be available for trading from June 22nd, 2020 onward at the 5Y tenor with a fixed coupon of 100 basis points.

Images Courtesy of M&G Investments

Featured Image Courtesy of IHS Markit

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