Sustainability and sovereign fixed income
In December 2016 the City of Portland, finding itself subject to criticism about individual holdings, decided to divest totally from equities and bonds in favour of “uncontroversial” assets such as sovereign bonds.
This move may be less socially progressive than it first appears.
Environmental, social and governance (ESG) integration in the equity and bond markets (assessing companies on the sustainability of strategy and practices and incorporating the conclusions into portfolios), is becoming more widespread.
This is complemented by engagement: holding companies to account on their ESG performance and pushing for improvement.
By contrast there has been little discussion on ESG integration or engagement for sovereign bonds, a pillar of many large asset owners’ portfolios.
In the future, the importance of ESG risks to nations is likely to increase as social and environmental challenges – such as social unrest or climate change – intensify.
As global power diffuses and international governance becomes less defined and more changeable, understanding countries’ exposures and responses will become more critical to making lending decisions.
Investors should focus on “medium to long tail” risks
ESG analysis is frequently used by corporate investors as a risk mitigation tool.
However, the relationship between ESG risk and sovereign bond performance is not linear; rising ESG risks may lead to relative outperformance of sovereign bonds in some cases.
For example in the wake of a cyber attack or a hurricane, investors will flee to the safety of sovereign debt. Borrowing insurance terminology we have classified these as “short tail” ESG events, and suggest that they should not be the primary areas of focus.
Investors looking to generate ESG alpha should rather focus on “medium” and “long tail risks”. These are defined as changes that build over time, impacting GDP growth rates and ultimately debt sustainability.
Figure 1: Short, medium and long tail risks to sovereign debt
Governance and social issues should be prioritised
When evaluating longer tail risks, sovereign bond investors should prioritise the analysis of governance and social issues, reversing the traditional ESG terminology. Japan provides an interesting case study in this.
Demographics, deflation and sustained low growth have created a challenging backdrop against which debt-to-GDP ratios have risen to unprecedented levels. Yet Japanese sovereign bonds have consistently performed well.
A strong government and institutions, such as the Bank of Japan, together with currency control and social cohesion, have enabled Japan to maintain its credit rating, despite the headwinds described above.
The challenge for investors is not just to gauge the effect of environmental and social trends on economies but also to understand the national governance frameworks in place to identify and mitigate those risks.
In this case, the strength of Japan’s legal and institutional infrastructure has afforded the economy a safe haven role even as economic growth has dwindled.
The vulnerability of emerging markets
Not all countries will be impacted by long tail ESG factors in the same way. Emerging markets, because of their weaker institutions, are more vulnerable.
Ironically much of the academic research that shows a link between ESG and sovereign debt performance has focused on developed markets, given better data availability.
Ultimately because of the tools available to developed market policymakers, including quantitative easing, fiscal repression and forced buyers, they are relatively immunised against the risks posed by long tail ESG events.
In evaluating emerging markets’ ESG exposures, the direction of travel is as important as the absolute exposures.
For example, the political response to social pressures is often dramatic, with consequences for all investors in all financial instruments.
Assessing how pressures are building through mining data, such as educational attainment and population growth, coupled with regular in-country engagements, ensures that risks are being effectively identified and monitored.
The focus should be on identifying the trend of the risks, rather than the tipping point; improvements are as important as deteriorations in generating alpha.
For example, in China concerns around pollution are high and could impact social stability. The central government has clearly identified this as a priority but it remains to be seen how effective local institutions will be in improving air quality to mitigate the risk.
Engagement activity with sovereign issuers by investors is lower than with corporates, but does occur.
Bond vigilantes, known for their ability to impose fiscal discipline on countries, have been a consistent feature of sovereign markets.
They usually limit their activities to emerging markets, where they are likely to have a larger impact. In emerging markets, more systematic engagement occurs by issuing countries with investors, which provides the opportunity for concerns to be raised.
Realistically, to effect ESG change, concerns need to be raised not just with Debt Management Offices but directly with governments. For example, at Schroders, we engage with G7 and G20 leaders about climate change risks.
Looking into the future we note that engagement could take on a geopolitical flavour. China is now the largest owner of US Treasuries; will governments become the bond vigilantes of the future?
As the global growth backdrop becomes more challenging, understanding the strength of the foundations on which countries are built is increasingly important to debt investors.
Embedding ESG analysis into the fundamental investment process (which is known as ESG integration) is an important way of ensuring that investors are well positioned to spot these structural shifts and benefit from them.