The Rise of ESG Fixed Income

According to our recent survey of more than 350 global institutional investors,1 61% are prioritizing the integration of ESG factors in their fixed income portfolios over the next three years.2 This validates the strong trend of asset growth in the evolving fixed income ESG universe now comprised of nearly 1,000 funds globally with total assets of $450 billion under management, with $41 billion in North America and $404 billion in Europe.3

Although most of these assets have been invested in active mutual funds, there has been a meaningful uptick in both the number of ESG fixed income exchange traded funds (ETFs) and their adoption by investors. In 2020, ESG fixed income ETFs had inflows of $12.9 billion, more than three times the previous record year.4  Inflows the first eight months of 2021 have already surpassed that figure.5 More than half (58%) of all respondents in our survey noted that they will most likely use ETFs as their preferred investment vehicle for increasing allocations to fixed income ESG strategies, with investors in North America (68%) having a stronger preference for ESG-related ETFs than those in Europe (50%).6

Global ESG Fixed Income Fund Universe

How can investors incorporate ESG?
There is no one standard approach to incorporating ESG into a fixed income portfolio. Methodologies vary from strictly excluding investments based on ethical or value considerations to ESG integration devoid of any negative screening. These diverse approaches can be broadly grouped into five categories:7

  • Exclusionary (Negative) Screening was the first ESG investing approach and it is still the most common. This method excludes specific companies, sectors or countries based on ESG factors and/or an investor’s values-based goals. The benefits of this strategy include mitigating reputational risk and helping to ensure that investors do not allocate funds to companies or sectors that directly conflict with their beliefs. Examples include religious investors who exclude investments in “sin stocks” or investors who align their portfolios with initiatives such as the United Nations Global Compact (UNGC)and exclude companies and/or sectors that violate UNGC principles.
  • Positive/Best-in-Class focuses on investment in sectors, companies and countries that have superior ESG performance relative to the universe or industry peers. This method is gaining attention because of the increasing availability of ESG data and research showing that companies with high ESG scores have the potential to outperform companies with low ESG scores over the long term.
  • ESG Integration is the systematic and explicit inclusion of material ESG metrics into the investment analysis and decision-making process. This is a more systematic investment approach than an overlay.
  • Thematic Investing allocates assets in line with specific ESG themes, such as those encompassed by the United Nations Sustainable Development Goals (UN SDGs), including climate change and carbon emissions reduction, health care, diversity or human rights. These strategies often have specific metrics that they hope to achieve. A common objective is investing in a way that aligns with the Paris Climate Agreement, which sets out a global framework to avoid catastrophic climate change by limiting global warming to well below 2°C and pursuing efforts to limit it to 1.5°C.
  • Impact Investing typically targets investments that are aimed at specific social and/or environmental issues. These investments often prioritize “impact” objectives over or at par with return/performance objectives and reflect specific targeted and measurable outcomes. Examples include funds that invest in renewable energy, conservation or affordable health care and education.

Common Methods of ESG Incorporation

These methods are not mutually exclusive; where feasible, they can be combined to achieve an investor’s overall investment objectives.

However, it is also important to note that fixed income is a much more diverse asset class than equities — spanning corporate bonds, sovereign and government-related bonds and securitized and private debt. The opportunity set to incorporate these methods has increased significantly for corporate bond investors as companies have responded to the importance of acknowledging ESG considerations. From providing more useful and relevant data points to the creation of bonds with specific sustainable projects or goals, a growing amount of corporate debt now meets ESG mandates. While this makes it possible for investors to be consistent in how they reflect their ESG values and objectives across both their equity and corporate bond exposures, it remains more challenging to assess sustainability risks of other fixed income security types, such as sovereign bonds and securitized products.

How are issuers participating in ESG?
Fixed income issuers have become an integral part of ESG adoption and asset growth. For an issuer to be properly rated from an ESG perspective, relevant and robust data must be available. Governments, municipalities and companies are more aware of ESG-related elements and, in some cases, have established new roles or divisions to work with the investment community. The resulting greater data availability has improved the accuracy of ESG ratings for bond issuers, allowing investors to more confidently focus on those with higher ESG ratings.

There are also specific securities that have defined responsible investment guidelines and strict requirements about how the proceeds of those investments are used. Although small when compared to the broader bond market, this universe of bonds is growing and currently stands at more than $300 billion of new corporate issuance through the first three quarters of 2021.8 Targeted at generating climate, social or other environmental benefits, these bonds typically fall into one of four categories:9

  • Green bonds. Started in 2007 with issuance from the EIB and World Bank, the push for more transparency in the green bond market has encouraged the development of indices that track the green bond universe. These indices have provided the means to track market developments, evaluate performance and assess market risk. Commonly used benchmarks include the Bloomberg Barclays MSCI Green Bond Index, the S&P Green Bond Select Index and the Bank of America Merrill Lynch Green Bond Index.
  • Social bonds. First issued by the Spanish Instituto de Credito in January 2015, social bonds follow a similar set of principles and quality-of-information requirements as green bonds but, as the name suggests, the proceeds are used to support social programs. Project examples include access to essential services (e.g., health, education and financial services), affordable housing and microfinance.
  • Sustainable bonds. Starbucks issued the first-ever US corporate sustainability bond in 2016. The bond raised $500 million dedicated to sourcing coffee that meets the company’s standards on measuring the environmental and social practices of its suppliers.10 Sustainable bonds differ from green bonds in that they offer issuers a broader mandate of acceptable environmental, social and governance uses for the proceeds of the bond.
  • Blue bonds. The youngest member of the sustainable bonds family, blue bonds debuted in October 2018 when the Seychelles in partnership with the World Bank issued a US $15 million bond.11 Blue bonds finance marine and ocean-based projects that have positive environmental, economic and climate benefits.

Choosing these bond categories allows investors to influence and have better views into the use of proceeds at the issuer level than they would have with general issues.

What are investors prioritizing?
In terms of how institutional investors are incorporating ESG issues into their fixed income portfolios, our research identifies best-in-class as the most popular ESG fixed income approach, with 49% of respondents using the method. Our survey also revealed regional differences in the incorporation of ESG preferences, with 42% of North American respondents employing best-in-class compared to 50% of European respondents. This trend was reversed for Impact investing, which was employed by 50% of North America respondents and just 34% of those in Europe.12

Once investors choose an ESG incorporation method, or a combination of methods, they must evaluate the investment opportunities and weigh the style of investing (active or index). Survey findings indicate investors favor certain styles based on what the specific ESG strategy entails. For a broad ESG strategy, an index approach is favored. For targeted social or targeted climate/environmental strategies, an active approach is favored.

Future Fixed Income ESG Strategy Allocations
By Tilt/Theme

The State Street Global Advisors Approach
Index investing can be an ideal way to gain exposure to broad ESG factors in a fixed income portfolio. But to do that, data must be aggregated to measure the performance of a company’s business operations and governance as it relates to financially material ESG challenges facing the company’s industry. This is why State Street Global Advisors developed R-Factor, a proprietary ESG scoring system that draws on data from multiple providers and leverages commonly accepted, transparent materiality frameworks to generate a unique ESG score for listed companies.

Street Global Advisors uses R-Factor to provide a best-in-class, index strategy focused on the investment-grade corporate bond sector. Launched in 2020, the SPDR® Bloomberg SASB® Corporate Bond ESG Select ETF (RBND) can be used as a core ESG building block to gain exposure to firms exhibiting certain financially material ESG characteristics. RBND is just one example of the different types of solutions from State Street Global Advisors that are available to help investors incorporate ESG into their portfolios.