Introduction

For institutions looking to introduce ESG into their investment portfolios, investment grade fixed income represents an ideal starting point. That’s not our contention—it’s an empirical observation drawn from the results of a study of midsize institutions in the United States. Among the 80 institutions interviewed for the study, investment grade fixed income is the No. 1 asset class for those considering and using ESG, topping even domestic equities.

Why are these institutions employing ESG in investment grade fixed income more than any other asset class? Investors are starting their ESG journey in investment grade fixed income in large part because the two categories of ESG and high grade bonds play similar roles in institutional portfolios, and because of the high degree of overlap in objectives and methodologies between investment grade fixed income and ESG based on commentary from survey respondents.

As adoption of ESG emerged and expanded, many investors pursued it for altruistic reasons. More recently, institutions have begun to realize that ESG can be correlated not only with environmental, social and governance impact, but also with corporate and financial performance. ESG is increasingly viewed as having the potential to identify non-financial risks that might be overlooked or minimized through traditional investment analysis. By helping investors assess major environmental and social risks, ESG may enhance long-term risk-adjusted returns.

Meanwhile, despite a prolonged stretch of historically low interest rates and a global pandemic, institutional investors’ objectives in investment grade fixed income haven’t changed. Within the context of their portfolios, institutions in the study still view investment grade fixed income first as a tool for capital preservation and downside risk management, and second as a source of outperformance within the bounds of strict risk constraints.

Those objectives align with the risk management benefits and potential for return enhancement associated with ESG. It is this alignment that has caused many institutions to conclude that adding ESG criteria to an investment grade portfolio can enhance resiliency and possibly performance, and that investment grade portfolios represent a logical and relatively seamless starting point for the integration of ESG into their broader organizations.

This is an important message for institutional investors today. Most institutions are still in the process of onboarding ESG. Two-thirds of the respondents in our study haven’t even started. But since most institutions acknowledge the necessity of considering ESG in their investment processes in some manner, large numbers of institutions will likely be exploring the best ways to do so in the months and years ahead.

These institutions will encounter a unique opportunity in the post-COVID-19 environment. In 2020, the combination of low interest rates associated with economic stimulus and an equity market boom caused major shifts in the composition of institutional portfolios. The spike in equity valuations left portfolios overweighted to stocks and underweighted to fixed income in general and to investment grade fixed income in particular. As institutions rebalance, they will be allocating assets to investment grade fixed income.

We believe this is an opportunity to either introduce ESG into their portfolios or to build on existing ESG allocations. More generally, due to the considerable overlap in objectives and methodologies, we believe institutional investors should consider investment grade fixed income as both a starting point and a foundation for the broader integration of ESG across investment processes and portfolios.