As corporate-bond investors embrace decarbonization as a goal in portfolio construction and management and benchmark selection, the question arises whether decarbonization targets are at odds with other desirable index attributes, such as liquidity. That is, if their selected index excluded less liquid bonds, would that have hurt the index’s emission profile?

Why bond liquidity matters in index construction?

Liquidity of bonds in an index is a precondition of its replicability, as the liquidity of constituents directly affects the cost of replicating the index. Tradability and liquidity metrics,1 when available, offer a superior measure of a bond’s liquidity. In their absence, size — the available units of a security or aggregated units of all substitutable securities — is a simple yet accessible proxy for bonds’ liquidity and is widely used in index construction. Corporate bonds with lower issuance size have tended to have less liquidity and wider average bid-ask spreads2 across different segments of the credit market.

Amid market stress, the average bid-ask spreads widened more for bonds with smaller amount outstanding

Amid market stress, the average bid-ask spreads widened more for bonds with smaller amount outstanding
March 31, 2020, represents the episode of market stress caused by the global outbreak of COVID-19. Feb. 28, 2022, is chosen as an arbitrary benchmark date. The sectors follow the sector definitions of the MSCI EUR Investment Grade Corporate Bond Index and MSCI USD High Yield Corporate Bond Index.

The variation of the bid-ask spread has also generally been lower for bonds with higher total amount outstanding. These observations were even more evident during periods of market turmoil, as shown by the orange and blue markers in the exhibit above.3

MSCI uses size measured by (1) total outstanding of a bond and (2) total outstanding of bonds issued by a firm4 as proxies for liquidity in this analysis. As the exhibit above shows, on average, bid-ask spreads were smaller for larger bonds, in both normal and stressed liquidity conditions.

Liquidity, as measured by size of a firm’s liabilities, varied across sectors

The average size of an issuer’s liabilities (total outstanding of all long-term bonds, with maturity of at least one year) varies across sectors. MSCI noted that the divergence between the size of issuers’ liabilities in different sectors was larger in the MSCI USD Investment Grade (IG) Corporate Bond Index compared to MSCI USD High Yield (HY) Corporate Bond Index.

It was also evident that companies in sectors with worse emission profiles have tended to be smaller — and hence had smaller bond pools with lower liquidity, as the exhibit below shows.

Issuers in high-emission sectors tended to be smaller, especially in investment grade

Issuers in high-emission sectors tended to be smaller, especially in investment grade
Total outstanding of long-dated bonds for each firm in different sectors of the USD credit market, excluding bonds with amount outstanding of less than USD 300 million and USD 200 million, for investment-grade and high-yield bonds, respectively. Emission intensity as measured by tons of CO2 equivalent per USD 1 million of economic value including cash (EVIC).

The measure of emission matters

Opting for higher liquidity, via larger size, inevitably increased concentration in our hypothetical indexes. As an unintended consequence, this might result in higher total emissions for the index, as larger companies have tended to have higher total emissions. We have observed this in all MSCI IG indexes.

Normalizing the emissions based on economic output (sales) or capital structure (using economic value including cash, or EVIC) is a reasonable approach to assess emission profile of an index and is widely recommended by regulators and industry-led initiatives.5

Building a hypothetical index with higher liquidity and lower emissions

MSCI simulated improved liquidity of a hypothetical index by applying (1) a minimum outstanding for each bond and (2) minimum total liabilities of each issuer (total outstanding of long-dated bonds). The carbon footprint of an index is measured by emission intensity, as prescribed by Partnership for Carbon Accounting Financials standards.6

For clarity, it measured total emissions as Scopes 1 and 2 (“S12”: orange line) and Scopes 1, 2 and 3 (“S123”: blue line) in the exhibit below, which summarizes the results. Improving liquidity by increasing the minimum size for bonds in the index improved the carbon footprint of the MSCI IG indexes, but the effect was less pronounced in the MSCI HY indexes, where the issuance was more homogeneous in terms of size (left column). Selecting firms with larger total bond liability improved the emission profile of the index, but increased concentration in the index as well (right column).

Overall, there was little evidence that improving liquidity of the constituents of the index worsened the emission profile of the hypothetical corporate-bond index or interfered with decarbonization targets. In fact, in the USD and EUR IG universes, where there is a wider variety of issuers than for high yield, selecting for bonds with large amounts outstanding improved the emission profile, as shown in the left-hand column of the exhibit below.7

Simulated indexes with larger bonds and larger issuers generally had better emission profiles

Simulated indexes with larger bonds and larger issuers generally had better emission profiles

Selecting larger issuers did not necessarily lead to the same results. For example, in the MSCI EUR IG Corporate Bond Index, companies in energy and utilities were among the larger issuers. For that reason, opting for larger issuers did reduce exposure to sectors with lower emission intensity and might have increased the carbon footprint of an index, as shown in the right-hand column of the exhibit above.

Despite the difference in patterns in different segments of the credit market, the constraint to improve the liquidity of a corporate-bond index did not inevitably worsen its carbon footprint. A careful selection using size and liquidity criteria may help owners to improve the emission intensity of their portfolio while opting for higher-liquidity bonds.

Source: MSCI

1These metrics include information on a given bond’s size, contractual features, bid-ask spread and order-book structure.

2The bid-ask spread does not provide the full picture of a security’s available liquidity. A better proxy for liquidity is the full order book, with bid and ask prices accompanied by volumes. But even this measure varies over time and does not contain all information about the hidden liquidity and tradability of a security.

3The increase in average spread of the MSCI EUR Investment Grade Corporate Bond Index for bonds with size larger than EUR 2 billion — especially for the bucket between EUR 2.5 billion and 3 billion — is due to the small number of bonds in these categories.

4The hypothesis is that bonds of the same issuer carry the same risk and to some degree are substitutable.

5“The Global GHG Accounting and Reporting Standard for the Financial Industry.” Partnership for Carbon Accounting Financials.


7For the USD HY universe, given the limited availability of Scope 3 emission data, we used only Scope 1 and 2 emission intensity.