In recent years, we have seen a significant increase in the number of investors that integrate environmental, social and governance (ESG) considerations into their fixed income strategies. This is especially true when it comes to corporate bonds. The use of our Country Risk Research & Ratings in sovereign bond investments is however still comparatively new and clients often ask me how our research can support them.
Country ESG research as a complement to traditional sovereign bond analyses
When it comes to the overall ESG performance of countries, there aren’t generally any big surprises. The more economically developed countries also perform well on ESG, and vice versa. Sovereign bond investors use this correlation to corroborate their own assessment of a country’s creditworthiness while notable discrepancies are used to identify issues that may have been overlooked by traditional economic analyses.
Greece is a good example of how country ESG research can potentially act as an early warning mechanism for sovereign bond investors. The country had a relatively good credit rating in the years leading up to the Greek government-debt crisis at the end of 2009. When you compare Greece’s governance rating to developed markets, it is however clear that the country had structural governance issues that were deteriorating long before ratings agencies downgraded them.
ESG momentum in frontier and emerging markets
Frontier and emerging markets offer the promise of greater returns for sovereign bond investors with a stronger risk appetite. The higher risk is reflected in both the weaker economic and ESG performance. Although properly benchmarking the risk is important, the country’s overall ESG rating is less useful when it comes to differentiating between the creditworthiness of countries that are already understood to be riskier bets. That is why many sovereign bond investors in these markets prefer to look at a country’s ESG performance over time.
Most countries, even those with fairly poor ESG ratings, will repay their debt on time unless something exceptional happens. The likelihood of such an event is often correlated to the stability of the country’s government. Investors can use historical data to identify ESG trends as a way of determining whether a country’s stability is increasing or decreasing. Positive ESG momentum manifested through, for example, the strengthening of government institutions and social stability are good signs that the country will remain stable. A country with negative ESG momentum, manifested through a growing number of corruption scandals and increased societal unrest, can show signs of being less stable and a riskier investment.
Mozambique and Ivory Coast are good examples of how ESG momentum can support sovereign bond investors’ analysis. While Sustainalytics’ country ESG rating for Mozambique was significantly higher than that of Ivory Coast in 2010, the latter’s performance continued to improve while Mozambique’s performance deteriorated (see chart below). By 2015, their ratings were just one point apart. However, Mozambique is currently facing a default episode, due to the mismanagement of its finances, while the investment climate in Ivory Coast has improved with a successful sovereign debt issuance, a credit rating upgrade by Moody’s and the removal of long-term international sanctions.
Does country ESG research truly add value?
Country ESG research attempts to measure the underlying characteristics of an economy that impact its productive capacity, such as its human and natural capital and institutional strength. In other words, ESG indicators attempt to capture factors that can be argued to precede or underpin changes in economic indicators, which measure the outcome of improvements in productivity. This difference in perspective explains, I believe, why country ESG research is such a good compliment to more traditional sovereign bond analyses.
Feel free to get in touch if you would like to learn more about our Country Risk Research & Ratings or receive a sample report.
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