The landscape of funds, be it mutual funds or exchange-traded funds (ETFs), adhering to environmental, social and governance (ESG) principles is dominated by equity products. As is the case with other conversations about smart beta and fundamentally weighted products, investors are wondering if ESG virtues can be applied to the fixed income space.

The short answer is “Yes, bonds and ESG are match.” Additionally, investors should expect more funds to marry the two concepts. In fact, the idea of virtuous investing potentially has important applications in the fixed income universe.

“Environmental, social, and governance (ESG) analysis is becoming increasingly important to fixed income asset managers, catching up to U.S. and global equity research where these factors are more firmly entrenched,” according to asset manager Legg Mason Inc. “Although favorable ESG scores may correlate with attractive investment opportunities, the reason has more to do with improving the ability of fixed income investors to correctly price the risk of bonds over longer time periods.”

Making Progress

A key driver of increasing ESG investing in the bond world are the credit rating agencies (CRAs) using ESG principles in their research and ratings. Progress is being made on that front. For example, Moody's Investor's Services, one of the major CRAs, is boosting efforts to integrate ESG considerations.

“Over the past three years, Moody's has been intensifying its effort to increase the transparency around how it incorporates ESG considerations into its analysis of credit quality,” said the ratings agency. “Moody's objective is not to capture all considerations that may be labeled green, sustainable or ethical, but rather those that have a material impact on credit quality.”

Last year, the United Nations-supported Principles for Responsible Investment (PRI) unveiled the ESG Credit Ratings Statement. Over 100 investors with nearly $20 trillion in assets under management and eight CRAs signed the statement.

Standard & Poor's, a rival to Moody's, has proposed including ESG assessments on corporate bond issuers that emphasize environmental risk profile, social risk profile, management and governance strength and how management teams handle and environmental and social risks.

“The longer a bond has until maturity, the greater the chances that factors affecting the risks inherent in the bond and the creditworthiness of the issuer will also change,” said Legg Mason. “While this creates an interesting challenge for investors, ESG analysis helps foster a longer-term perspective and a more comprehensive understanding of broader risk factors over time.”

Accessing ESG Corporate Bonds

Investors should expect more corporate bond funds tied to ESG principles to come to market. Earlier this year, iShares, the world's largest ETF issuer introduced the iShares ESG USD Corporate Bond ETF (SUSC) and the iShares ESG 1-5 Year USD Corporate Bond ETF (SUSB). Those ETFs hold corporate debt “issued by companies that have positive environmental, social and governance characteristics while exhibiting risk and return characteristics similar to those of the parent index of such index,” according to iShares.

Credit quality is strong across both ETFs. For example, 90% of SUSB's 98 holdings are rated A or BBB while over 89% of SUSC's 190 holdings are rated A or BBB.

Emerging markets debt, a prime destination for risk-tolerant investors looking to boost portfolio yield, could be fertile ground for future ESG bond growth. Efforts in China and India, among other developing economies, to cut pollution and reduce carbon footprints, could drive the use of ESG bond ratings outside the U.S.

“Still, we see signs that the market is about to become more investable for institutional investors,” said MSCI. “Issuers are starting to hold themselves to higher standards as they work to attract foreign capital.”

Data suggest that over the long-term, bonds with high ESG ratings outperform those with low ESG ratings or issuers lacking ESG ratings.