The coronavirus epidemic has further accelerated the rise of ESG into the investment mainstream. As deficits skyrocket, bond investors have an opportunity to engage with governments on climate change, argues Thomas Dillon.
Demand for environmental, social and governance (ESG) investment strategies exploded after the COVID-19 outbreak struck in early 2020. According to data provider Morningstar, record fund sales helped deliver a 50 per cent surge in assets under management in sustainable mutual funds, which in turn hit a record of almost $1.7 trillion.1
Traditionally, ESG has been the preserve of equity investors. For example, although the global bond market is roughly 25 per cent bigger than the global stock market, Morningstar reckoned that, as of mid-2019, fixed income strategies made up only a fifth of all the assets of those mutual funds it labelled ‘sustainable’.2 However, that is beginning to change as bond investors wake up to the ESG opportunity and responsibility.
ESG in the sovereign debt market remains embryonic
Although governance considerations have long been considered important to emerging markets, environmental and social issues have historically tended to receive little, if any, attention from sovereign debt investors, even though they can also be crucial to long-term economic growth and stability. Instead, the focus has been on factors such as the outlook for inflation and fiscal and monetary policy.
It is easy to see why the integration of ESG factors in sovereign markets is in its embryonic phase. For a start, because sovereign debt is traditionally considered a risk-free asset class, there has been a tendency to underestimate the importance of ESG integration, at least in developed markets. It is also harder to assess ESG-related risk on debt issued by two different countries compared with two different companies. That is partly due to a lack of consistency in defining and measuring material ESG factors, and the limited availability of data.
However, this is finally changing as a growing body of academic and industry research points to a relationship between ESG factors and sovereign bond risk and pricing. Increasingly, sovereign investors are realising environmental and social issues can have a material impact on valuations, particularly in emerging markets.
For example, before investing in the sovereign debt of a big oil-producing nation, investors might want to know what, if any, steps the government is taking to prepare for a global shift away from fossil fuel consumption. Likewise, measures of income inequality and social cohesion can foreshadow social unrest that impacts valuations.
Nevertheless, there are certain realities that are hard to ignore, including the regulatory incentive for financial institutions to hold assets deemed safe and liquid. Institutional investors such as banks, pension funds and insurers are often mandated to hold a minimum percentage of their total assets in domestic sovereign bonds or the deepest and most liquid markets. That means, unlike investing in equities or corporate bonds, the option to take your money elsewhere – the ultimate threat – may not be available.
Take the case of US Treasuries. The US would arguably score poorly on many ESG criteria: it is one of the world’s biggest polluters, has deep social divisions and high inequality, and is the world’s biggest arms manufacturer. At the same time, it is the world’s largest and safest government bond market: exiting it would be inconceivable for many investors.
Besides, given the size of government bond markets, it has – to date – seemed unclear whether even the biggest investors hold much, if any, sway. That is all the truer in an environment where central banks stand determined to mop up any excess supply, as has been the case for over a decade. The fine line between making an objective ESG assessment and straying into political territory only adds to the problems facing big global investors with reputations to protect.
The engagement challenge
Engagement has long been considered a critical part of a responsible investment process, particularly among equity investors, to drive positive changes in companies. However, it is far less common between the owners and issuers of debt – especially in sovereign markets. A 2017 report by the Principles for Responsible Investment – a UN-supported network of investors working to promote sustainable investment – showed 58 per cent of signatories did not engage with sovereign issuers.3
The increased focus on ESG factors by both clients and regulators is providing investors with an incentive to integrate ESG considerations into mainstream sovereign credit analysis, by building a more structured and in-depth framework.
If climate change and some of the other pressing issues facing the world are to be addressed with sufficient haste, it is hard to see how private sector actors will be able to bring this about on their own. Governments, too, need to step up to the plate. The extent to which deficits have skyrocketed due to the pandemic means many will be in desperate need of funding for years to come. Even if divesting may not always be an option, this should provide debt investors with an opportunity to engage more actively and effectively with sovereign borrowers.
1. Attracta Mooney and Patrick Mathurin, ‘ESG funds defy havoc to ratchet huge inflows’, Financial Times, February 6, 2021
2. ‘Fixed income has been slow to embrace ESG factors’, CAMRADATA, August 27, 2020
3. ‘ESG engagement for Sovereign Debt Investors’, Principles for Responsible Engagement, 2020
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