With Moody’s putting Austria, France and the UK on negative credit watch last week, environmental, social and governance issues may seem irrelevant to the government bond market at present.
Yet MSCI, the index and information provider, recently launched a new tool allowing investors to assess the exposure of their sovereign bond holdings to ESG issues.
There is increasing demand for information on how ESG factors affect sovereign borrowing, according to Hewson Baltzell, head of product development at MSCI.
While the financial crisis is not directly responsible for this increased interest, it has focused attention on the need for investors to understand the risks their portfolios contain. “Investors are now looking more carefully at countries and after recent events they may be sceptical about bond ratings anyway,” Mr Baltzell says.
It is important for investors to be aware of the risks countries face and how that might lead to volatility, says Mark Robertson, head of communications at Eiris, the ESG research group, which also rates sovereign bonds according to ESG criteria. “Our ratings show that the extent to which countries differ in their approach to tackling key ESG challenges … is striking,” he adds.
Another factor is the growing number of investors that have signed up to the United Nations’ Principles for Responsible Investment: as of October 2011, 915 institutions representing $30tn of assets under management were signatories. “If investors are applying ESG analysis to more asset classes, we need to have good coverage in fixed income and sovereign bonds are a big part of that – they make up more than half of the bond market,” Mr Baltzell adds.
The PRI has seen strong interest from its signatories regarding how ESG issues can affect fixed income investments, and several signatories have launched products in the field, says James Gifford, executive director of the PRI.
“In the case of sovereign bonds, it is clear ESG issues such as political and social risk can have a sizeable impact,” he says. “For example, the current situations within the eurozone, in Hungary, and implications from the Arab spring all demonstrate the importance of investigating the relationship between ESG issues and a country’s credit worthiness.
“However, a greater understanding is required to fully appreciate how these issues impact sovereign credit ratings and capital markets.”
The MSCI ratings cover 90 countries responsible for 99 per cent of sovereign bond issuance and provide information going back five years. The ESG ratings on Greece, Italy, Spain, Portugal and Ireland in 2007 were much lower than their conventional bond ratings, Mr Gifford points out.
This is a point backed up by Raj Thamotheram, president of the Network for Sustainable Financial Markets. “There’s little doubt that the traditional rating process for sovereigns is deeply flawed. What’s happening in Greece and the US, for example, is far from being a ‘new’ development,” he says.
“Similarly, the way the credit rating agencies ignored corruption, social inequality, and other lead indicators of risk in Egypt is yet another example of the very limited – and misleading – approach of the mainstream rating models,” he adds.
A report released last year by Bank Sarasin* points to the positive impact that sustainability can have on the performance of sovereign bonds. “Sustainable economic development is a basic prerequisite for being able to service sovereign debt,” it says.
“Although ‘traditional’ credit ratings are designed to assess a country’s future ability to perform and meet its payment liabilities, most recently they have, in many cases, tended to be more of a barometer of current performance than an indicator of future performance. Sustainability criteria provide a useful supplementary analytical tool here, by serving as leading indicators.”
The performance of the sovereign bonds of sustainable countries has been better than average for both mature and emerging economies, it adds, with the most important drivers of performance being ecology, education, health and public governance.
An ESG approach can highlight future problems in some economies that are not reflected in traditional ratings and might give investors pause. “Both China and India have a number of environmental, social and governance problems they are wrestling with that are not reflected in the market,” Mr Baltzell says.
China scores lower than its peers on key governance indicators such as civil liberties and political rights, adds Mr Robertson. It has also shown deterioration in environmental and social areas, especially in carbon dioxide emissions and public education.
But concerns are not restricted to emerging markets: the US, which has the world’s largest and most liquid sovereign debt market, is ranked only 34th in Eiris’s ratings while recently, a coalition of investors, NGOs and universities urged the Bank of England to investigate how the UK’s exposure to polluting and environmentally damaging investments might pose a systemic risk to the UK financial system and long term growth.
Ben Caldecott, head of policy at Climate Change Capital, one of the signatories to the letter, says MSCI’s move is important, “but ultimately this ESG information needs to be embedded in existing ratings, not separated out”.
* Sustainable fulfilment of sovereign obligations: Sustainability and performance of sovereign bonds, July 2011
