
Sovereign bonds: Spotlight on ESG risks
This report explores the use of environmental, social, and governance (ESG) analysis as a potential risk-reducing and return-enhancing tool for investors in developed-country sovereign bonds. The report suggests that ESG factors are material to both creditworthiness and investment performance.
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OVERVIEW
The stakes
Sovereign bonds issued by developed countries have long been seen as a safe haven for institutional investors’ assets. These bonds have performed well historically, and they are widely used to diversify investment portfolios, manage risk, and deliver stable returns. As a result, sovereign bonds make up a significant portion of pension funds’ and institutional investors’ portfolios. The report identifies investors’ increasing interest in using environmental, social and governance (ESG) analysis when appointing asset managers. Moreover, academic and investor research has highlighted correlations between ESG factors and credit risks.
Governance failings
The Euro Crisis highlighted the inherent risks of investing in sovereign bonds. Governance failings are amongst the ESG factors that have a strategic impact on investor performance. The report highlights a significant correlation between corruption and sovereign bond performance. Research has shown the implications for investors of different governance structures, which could be important to consider when assessing bonds.
Social factors
The report highlights that social factors are material to creditworthiness, and they may impact investor performance. Societal challenges facing sovereign nations, social tensions, or demographic factors, such as the underlying demographics of the population, may influence government decisions and subsequent credit ratings. The report cites research that there is a strong link between social factors and credit risks.
Environmental factors
The report outlines environmental factors that affect both creditworthiness and investment performance. Research had shown that major environmental challenges, such as natural disasters, environmental degradation, and climate change, have severe macroeconomic implications, as well as implications for individual sovereigns. Recently, some investment managers have started applying ESG criteria to the countries they invest in.
ESG analysis and materiality
The report suggests that ESG analysis has material relevance to creditworthiness and investment performance for sovereign bonds. Research reveals that a large discrepancy between ESG performance and credit ratings is a strong indicator of future downgrades. Using ESG analysis in addition to traditional financial and economic data is shown to be a tool for lowering portfolio risk and enhancing returns.
The role of credit ratings agencies
Credit ratings agencies have an undeniable influence on investors and regulators. The report highlights that ESG analysis is not yet systematically incorporated into credit ratings. It recommends that credit ratings agencies consider a more systemic analysis that captures risks regardless of whether an individual analyst considers them to be relevant in the short term.
A question of data
ESG analysis depends on quality quantitative and qualitative data. The report has recommended that more qualitative information be put into quantitative form for greater ease of analysis. Quantitatively, research carried out by some leading service providers indicates that countries with high ESG scores outperform other nations regarding performance.
Key findings
Applying ESG analysis to sovereign bond management can possibly give insights into creditworthiness and investment performance. Also, institutional investors are demanding ESG’s application when appointing asset managers, and having access to quality data in both qualitative and quantitative forms is vital.
The report makes several key recommendations, most notably for credit ratings agencies to consider a more systemic analysis that captures risks regardless of whether an individual analyst considers them relevant. Moreover, the report recommends that institutional investors increasingly examine ESG factors when appointing asset managers, given the correlations between ESG factors and credit risks. Finally, the report implies how investors should consider the potential consequences of environmental, social, and governance factors in economic analyses of sovereign bonds.