Taking the leap

Read this article to understand:

• How applying a climate lens to a core portfolio can help balance climate and return objectives
• The importance of maintaining a broad investment universe
• Key tools and approaches to build robust portfolios for the long term

Most institutional investors have significant allocations to corporate credit within their portfolios, tied to financial objectives. As they develop and implement transition plans, their investments will need to continue delivering returns while evidencing credible alignment to decarbonisation. This creates a challenge.

In the years immediately following the COVID pandemic, low-carbon investments were performing well. There was no visible trade-off between sustainability and solid returns. However, from 2022 onwards, the onset of inflation and an energy crisis led to a divergence. High-emitting sectors like energy and industrials outperformed, while many low-carbon portfolios lagged, being overexposed to sectors, like renewable energy, that were underperforming. 

The perceived trade-off between low-carbon investments and returns became more evident. Waning confidence among some investors, coupled with the politicisation of ESG, led to a general decline in public commitments to low-carbon investments. 

However, this idea of a trade-off reflects a narrow implementation approach rather than an inherent limitation. A broader, more flexible framework can mitigate its effects.

Moreover, the introduction of more stringent climate requirements in some jurisdictions is prompting investors to engage more intensively with the climate profile of their portfolios. Recent research shows that annual climate-finance flows grew by an average of 26 per cent between 2021 and 2023, compared with growth of just eight per cent from 2018 to 2020. If sustained, this trajectory could scale annual flows from today’s low-trillion-dollar levels to around USD6 trillion per year by 2028 (see Figure 1).¹

The direction of travel is towards credible transition plans, better disclosure, and alignment with global standards. This is sharpening investors’ focus on how to balance regulatory expectations, net-zero ambitions and long-term return goals.

In this context, asset owners need practical tools to assess the credibility of companies’ transition plans. They also need investment strategies that balance benchmark sensitivity, liquidity, and long-term transition and investment outcomes.

We believe this can be achieved. Taking our approach to climate credit as an example, we outline the key elements that can align a portfolio to net zero while maintaining a core investment-grade return profile.

Applying a climate lens to the core portfolio

Balancing returns and climate objectives starts with applying a climate lens to the whole core investment-grade portfolio rather than treating it as an overlay. We can then take a sophisticated approach to preserve diversification and minimise structural sector biases.

Crucially, this involves recognising that, in every sector of the economy, some companies are better equipped for the net-zero transition and more resilient to the effects of climate change than others. By applying this “readiness” filter across sectors, we can access opportunities across the full fixed-income universe. 

Within this pool, thorough fundamental credit research will help find companies that can also deliver strong returns. Adding active management and a disciplined portfolio construction approach can then help a portfolio deliver competitive returns, even compared to a non-screened index.

Maintaining a broad opportunity set

Establishing a broad and diversified investment universe is essential to building a robust allocation.

First, to support this and maintain the integrity of the allocation from a climate perspective, we have designed a transition roadmap, with set targets and deadlines within a clearly defined investment framework. This can also help us decide which companies to engage with, and how to support them in their net-zero transition.

Then, focusing on companies’ business models means we don’t have to limit our investments to labelled bonds (like green, sustainable, and sustainability-linked bonds). Instead, we identify businesses that are decarbonising their whole operations and managing their climate risks efficiently. This allows us to choose from a much broader opportunity set (see Figure 2).

Our proprietary climate-risk model underpins this approach. We assess top-down transition risks across 159 industry sectors. Within each sector, we then assess individual issuers on their emission disclosures and carbon reduction targets; their climate strategy and governance; their climate risk measurement and scenario analysis; and their capital expenditures. 

This enables alignment with ISSB and similar standards and provides a broad, diversified investment universe. It also allows us to identify opportunities in sectors often overlooked by traditional sustainable strategies. These include carbon-intensive industries, where we think companies leading the transition can offer both resilience and return potential. 

For example, the chemicals sector is often viewed as incompatible with sustainable investment due to its carbon-intensive production processes, reliance on fossil-fuel feedstocks, and exposure to hazardous substances. However, our research highlights that certain specialty chemical companies act as enablers of the transition. In core end-markets such as municipal water, oil and gas, mining, and industrial processes, advanced chemical solutions can materially reduce water usage, improve energy efficiency, and lower emissions intensity. 

From an investment perspective, climate risks such as regulatory tightening on hazardous chemicals, water scarcity, and evolving environmental standards are not just headwinds. They actively drive capital expenditure, product innovation, and shifts to more sustainable inputs, which can create near-term cost pressures but also underpin long-term growth and credit fundamentals. 

In this context, assessing transition alignment requires a forward-looking, company-specific approach focused on innovation, execution, and financial outcomes. Not only can this support a portfolio’s long-term risk-and-return profile, it is also a more robust way to meet regulatory climate requirements and net-zero commitments.

Identifying key sources of investment performance

The next step is to strengthen the portfolio’s long-term risk-and-return profile by capturing multiple sources of performance. We have several tools at our disposal for this process.

One is to take a top-down approach to optimise the portfolio’s active duration and credit beta (i.e. capturing market returns). But to avoid overreliance on the direction of credit spreads, we believe a robust portfolio construction process – particularly around sectors and curves – can enhance not only efficiency but also portfolio resilience.²

While efficiency seeks to maximise returns through an optimal risk allocation across the credit universe, it is backward-looking, typically assumes normal market conditions and can leave portfolios exposed in risk‑off environments. 

Resilience, by contrast, looks beyond historical volatility. We consider factors such as mean‑reversion potential (i.e. the potential for an asset’s price to move back to its long-term average after a sharp rise or drop) and the likelihood of capital gains or losses under stress scenarios. This provides us with deeper insight and supports the construction of portfolios that can better withstand shocks and recover more effectively (see Figure 3). 

We also look to offset some of the natural sector underweights created by taking a climate lens (like energy). For example, we use correlation analyses and portfolio optimisations to reduce the risk of underperforming in an energy rally. 

Figure 3: Calculating resilience

For Illustrative purposes only.

Source: Aviva Investors, as of December 2025.

Our second tool is bottom-up issuer selection, to capture alpha (i.e. returns above those of the benchmark). In today’s environment of compressed spreads and increasingly asymmetric risk profiles, we take a disciplined, high‑conviction approach to issuer and security selection, underpinned by robust, value‑driven and forward‑looking fundamental research. This enables us to identify issuers whose creditworthiness is improving and where there are clear drivers for revaluation.

It can be tempting to add significant amounts of high-yield bonds to generate alpha, but as these also carry higher risk, investors should set a reasonable limit. We focus on carefully selected rising stars and catalyst-driven issuers (i.e. issuers whose bond price is expected to be significantly changed by a specific event or announcement). 

More broadly, we aim to enhance portfolio outcomes by switching between opportunities with comparable efficiency and resilience profiles, rather than continuously increasing overall risk. This approach supports more consistent performance across market cycles.

Beyond that, allocations that integrate climate considerations can be positioned to exploit market inefficiencies created by the net-zero transition. 

Credit markets often struggle to price long-term, non-linear risks like climate change. By identifying transition leaders early across economic sectors, we can allocate to bonds we think look undervalued, and to issuers we believe are better positioned for net-zero. We think these can outperform over the long term, once markets become better able to price the transition.

Similarly, thorough fundamental research of issuers that provide mitigation and adaptation solutions to climate change can help us uncover businesses that offer a complexity premium, and companies that are more insulated from cyclical trends. 

Embedding downside protection

Downside protection is a critical component of thoughtful portfolio construction. This includes actively spreading our risk exposure between bonds with shorter and longer maturities, and the deployment of selective hedges to shield a portfolio against adverse market conditions (see Figure 4).³

Just as importantly, being aware of specific risks and deciding what bonds to avoid can also boost outperformance. For instance, companies that ignore the low-carbon transition may face sudden regulatory fines, carbon taxes, business model disruptions, or obsolescence. That will also increase the risk they become “fallen angels” (dropping from investment grade to high yield). 

Figure 4: The proportion of issuers with Fitch Ratings climate vulnerability scores above 45 increases from two per cent in 2025 to almost 30 per cent in 2050

Source: Aviva Investors, Fitch Ratings. Data as of 8 March 2023.

Recent experience highlights these risks. Analysis by Charles River Associates found that, between 2020 and 2024, S&P issued nearly 100 utility credit downgrades driven heavily by climate-induced wildfire and severe weather risks across parts of the US.⁴ Meanwhile, Fitch estimated in 2024 that 20 per cent of the corporate issuers it rates could face a downgrade by 2035 due to climate-related risks.⁵

By integrating forward-looking climate considerations into credit analysis, investors can avoid issuers at risk of such downgrades before that risk is fully reflected in spreads.

We also aim to protect returns by taking a tactical valuation-based approach to labelled bonds. Some labelled bonds include a “greenium” – a premium that investors pay for the label. By focusing on issuers’ whole business model, we can select those companies that align with our climate ambition, and then choose whether to buy their standard or labelled bonds, depending on how expensive the greenium is. This helps us avoid sacrificing yield for the sake of a label.

Supplemented by engagement

As well as deliberate investment practices, active engagement can help a portfolio shift to net-zero by influencing issuers’ transition plans, capital allocation and emissions trajectories, enhancing long-term investment returns and improving real-world outcomes.

For example, in our targeted engagement programme, we ask issuers to set near-term and net-zero science-based targets, and to use industry ratings such as CDP (formerly the Carbon Disclosure Project). Where barriers exist, we try to explore credible alternatives to drive companies’ net-zero progress. That can in turn improve the risk-return profile of a portfolio over time. 

It is worth noting that bondholders have a distinctive role in engagement. They can express their views at each bond issuance – often multiple times a year. They also have a unique opportunity to engage with issuers where the influence of equity investors is limited, including private companies and state‑owned or state-controlled utilities. Many of those are among the largest global carbon emitters and rely heavily on debt to fund their capital expenditures. By engaging with them, we have a chance to drive meaningful real-world change while managing long-term credit risk.

Reflecting the real economy

More regulators are adopting international standards – albeit with local adaptations – and firms are increasingly complying with transition requirements. In this context, we believe it’s time for core fixed-income allocations to incorporate a broad and thoughtful climate approach.

Combined with active management and disciplined portfolio construction, such an approach can allow bond investors to support the transition without succumbing to crude sectoral biases or simplistic “label shopping” that can lead to underperformance.