ESG ratings make their mark on developed markets

By: Alex Rohner, Fixed Income Strategist, J. Safra Sarasin Sustainable AM

Fixed income investors increasingly recognise that ESG risks, also for developed market sovereign issuers, have the potential to materially affect investment outcomes. We have found that our country-specific income-adjusted ESG ratings explain a significant portion of the mark-to-market credit risks in the sovereign space, particularly for groups of countries with lower ratings, less institutional support and a wider dispersion of credit spreads. Our proprietary ESG framework allows us to identify red flags that may not influence performance in the short term, but could carry substantial risks for investors in the medium to long term.

ESG approach expands into the developed sovereign space

Numerous studies show that ESG factors can be important drivers of financial asset performance by influencing investors' preferences with respect to expected future returns, diversification and risk mitigation. Traditionally, the inclusion of ESG criteria in the investment selection process for both equity and fixed income investments has been straightforward for private sector companies. That said, attention has also shifted to extending the ESG framework to developed market sovereign bond markets in search of superior risk-adjusted returns. Traditional sovereign credit analysis focuses on:

• The strength and diversity of the respective economy, the ability to produce the necessary output to repay the debt.
• The fiscal position, i.e. the amount of debt relative to outstanding GDP.
• The interest rate coverage, the ratio of interest payments to taxes.
• The exposure to various risks, such as funding or political risks, etc.
• The quality of governance is also assessed.

While the last point of ESG, G, takes into account an important part of the ESG framework, traditional analysis may not capture medium and long-term trends that may affect the ability of issuers to repay debt. ESG is therefore an important complement to traditional sovereign debt analysis and can provide early warning of potential problems.

The effectiveness of ESG scores for developed market sovereign bonds may be limited in the short run…

However, it may take time for a low sovereign ESG score to be reflected in significantly lower yields. On the one hand, unlike the private sector, sovereign debtors in developed markets can always seek to issue more debt to meet their obligations. This is especially true if government issuers have the strong backing of a credible central bank. In that case, their local currency government bonds may outperform for a considerable time. Secondly, since a high yield to maturity is a key factor in the investment performance of a sovereign bond, even a sovereign with a low ESG score can perform well, if it manages to "go for broke" for long enough.

… but usually not in the medium or long term.

Ultimately, bad fundamentals always manifest themselves, usually in a non-linear fashion, in the form of a sudden and shocking risk-off event. This is the key to understanding the value of ESG scores. A good score reflects stronger fundamentals that ultimately lead to better policies and can substantially reduce the risk of negative outcomes. This is why countries with a high ESG score should have fewer defaults and offer better risk-adjusted returns over the medium to long term. We now analyse whether this is already reflected in the current market assessment of credit risk.