Investment Grade Fixed Income and ESG
Although investment grade bonds play a variety of roles within institutional portfolios, the results of our study make clear that protecting capital and mitigating downside risk take precedence over any other objectives.
Approach to risk management is the No. 1 criteria evaluated by the institutions when selecting an external manager for investment grade fixed income. Reinforcing that fact, institutions in the study say they seek out investment grade fixed income managers with a track record of outperforming during “risk-off environments,” rather than those who outperform in more normal conditions.
TOP OBJECTIVES IN INVESTMENT GRADE BOND PORTFOLIOS
Endowment/Foundation
“We try to maintain principal preservation at a minimum. [We] seek fixed income returns that counterbalance riskier assets in periods of economic distress and uncertainty. The goal is to strike the right balance between risk and return, without overreaching for yield.”
Corporate Pension
“Our first priority is to match the duration to the liability.”
Endowment/Foundation
“The primary objective of our IG fixed income is to provide a liquid safety net or backstop to significant disruptions to the equity markets. Our high dependence and high draw require a significant allocation to high-quality, short-duration fixed income. We are less concerned with outperforming a benchmark, peers or inflation.”
Corporate Pension
“We’re typically looking for alpha plus. We’re looking to slightly outperform, but we don’t want to take a lot of risk.”
Public Pension
“Our long-duration portfolio consists of mostly investment grade fixed income. Its objective is to be an equity risk hedge while providing opportunistic alpha.”
Endowment Foundation
“We would like to see our portfolio outperform the benchmark, mitigate risk and offer a stable and fairly consistent return within our portfolio… In the current environment, our fixed income portfolio offers a measure of liquidity that today is more important than it was one year ago.”
Note: Based on 80 respondents. The chart provides a sampling of the reasons cited for each objective. Source: Greenwich Associates
Although many U.S. institutions have yet to adopt ESG criteria, it appears ESG is on course to eventually become part of the investment process for most institutional investors. About one-third of the institutions participating in the study are using ESG in their portfolios today. Of the rest, two-thirds say they are either actively considering adopting ESG or might do so in the future. Only 16 of the 80 institutions say they have no interest at all in adding ESG to their portfolios.
In some cases, ESG adoption is mandated by boards or other organizational directives. That’s true for about 45% of study participants. However, for the majority of current ESG users, the decision to start employing these criteria was taken independently by the investment team.
What’s driving investors to embrace ESG? In the past, the decision to introduce ESG into an investment process was driven mainly by the desire to do the right thing. Institutions adopted ESG to get their portfolios into alignment with their own values or those of their clients/participants, or as a means of having a positive impact on the environment or society. This describes the motives of about half the current ESG users in the study.
However, in recent years institutional investors have become aware of a growing body of evidence suggesting a correlation between ESG and performance—both corporate and investment. More than one in five institutions in the study say their adoption of ESG was purely an investment-based decision, while about a quarter say their choice to adopt ESG was driven by a combination of values-based and investment-based factors. As a representative of a union pension plan explains, for their organization, “It was both investment-based and values-based. We think that the correct application of ESG considerations can and should meet both objectives.”
Investment factors appear to be playing an even more central role for institutions currently considering ESG. As shown in Exhibit 7, the top two goals for institutions considering ESG are enhancing returns and reducing risk, with positive impact ranked third. Both public and corporate pension funds are prioritizing return enhancement and risk mitigation over positive impact. Only endowments and foundations rank making a positive impact on society or the environment as more important than improvements in risk management or long-term risk-adjusted returns.
Some of pension funds’ increased emphasis on investment implications could be related to the Department of Labor’s ruling in October 2020 that investment decisions must be based on “pecuniary” factors, and that plan sponsors cannot sacrifice investment performance for other considerations. About 30% of the corporate pensions in the study say the DOL ruling had a meaningful impact on their approach to ESG. A study participant from a corporate pension explains that, from his perspective, the DOL ruling “validates the belief that ESG should only be considered if it affects investment performance.”
ESG DECISIONS LARGELY UNAFFECTED BY 2020 CRISES
Although the COVID-19 crisis is accelerating many trends in the economy and society, it seems that ESG adoption is not one of them. In recent months, market observers have speculated that disruptions caused by the global pandemic and social unrest over racial injustice could be speeding the adoption of ESG among institutional investors. However, among institutions in the study, about three-quarters say social unrest had little or no impact on their approach to ESG, and nearly 80% say the same about COVID-19. As one representative of a corporate pension fund explains, “We’re looking at long-term trends versus immediate [factors].” Adoption of ESG appears to be one of those long-term trends.
INSTITUTIONS MOVE BEYOND BOLT-ON ESG APPROACHES
When ESG first began taking hold in the institutional space, investors often introduced it into their portfolios in the form of negative screens that excluded companies or securities with low ESG ratings, or through dedicated ESG allocations or funds. Today, rather than pursuing these incremental or siloed approaches, more than half of pension funds and 42% of endowments and foundations say they prefer a holistic integration of ESG criteria into their investment process. Institutions opting for something less than full integration embrace a range of approaches, including positive, negative and norms-based screening, thematic investing, impact investing and corporate engagement.
As recently as a decade ago, few U.S. institutions considered ESG factors when making investment decisions. Today, nearly half the institutions participating in our study say they are more confident in trusting an investment process that accounts for non-financial elements of company performance.
As institutional investors adopt ESG, many are using investment grade fixed income as a starting point. In fact, the institutions in our study employ ESG in investment grade fixed income more than any other asset class.
These institutions chose to introduce ESG into investment grade fixed income because they recognized the close alignment between high grade bonds and ESG in terms of objectives and methodologies. In investment grade fixed income, institutional investors prioritize risk management as a means of preserving capital and generating alpha within strict risk constraints. Alongside creating positive environmental and social impact, ESG is likewise focused on mitigating downside risk, and thereby potentially improving long-term risk-adjusted returns.
Because ESG seeks to uncover non-financial risks, the addition of ESG analysis may make an investment grade fixed income portfolio more resilient. Because investment grade fixed income overlaps with ESG investing in approach, the asset class can serve as an ideal starting point for ESG adoption.
"In our work with advisors and consultants, we are finding that mitigation of long-term risk becomes a higher priority in a protracted period of low rates when extraordinarily accommodative fiscal and monetary policies suppress short-term risk. Our philosophy is based in our belief that ESG is primarily a long-term risk mitigator. Equity investors may be more willing to accept long-term risks if the prospects for short-term profits look good. Investment grade fixed income investors never earn enough in the short term, especially in low rate environments. They must consider longer-term risks, which may explain why institutions look at IG fixed income first for ESG."
- Peter Coffin, President and Founder