For one thing, it is less straightforward. Take for example engagement, central to ESG when investing in individual companies. Shareholders have voting rights and other means of influencing company management. Bond investors cannot expect to exert the same level of influence over a sovereign government. There are challenges around data and, crucially with country ESG analysis, the advantage enjoyed by higher income countries.
Demand for sustainable fixed income is growing and clients want solutions. Bonds are as integral to investor portfolios as ever, currently presenting the most attractive yields in years.
There is no simple answer, but there is no doubt ESG and sovereign fixed income are compatible. A well-constructed framework can address challenges and effectively integrate ESG.
We are also in no doubt that this area will continue to change and evolve. We will be ready to do the same.
Addressing the challenges
We agree with the World Bank’s succinct summary: “lack of clarity, the ingrained income bias, and poor environmental data quality”. Where does one go from there?
Our starting point is to create a sustainable sovereign investment universe. The problem is concepts of sustainability vary greatly. Our solution is to use the 17 UN Sustainable Development Goals (SDGs), giving equal importance to each, as an anchor point. The equal weighting prevents us overlaying personal biases into client portfolios. The SDGs are transparent and independent, with deep coverage and acknowledged as a blueprint of sustainable issues.
We look for countries outperforming on SDG scores versus countries of a similar level of development or national income. This avoids the inherent income bias. A clear and credible strategy to address climate change is essential, and a net zero pledge in a policy document – assessed with data from the ‘Energy & Climate Intelligence Unit’ – a minimum requirement.
Additional social criteria is overlaid to strengthen our framework. We use an independent source – ‘Freedom House’ – to assess democracy and political freedom. Its measure of civil and political freedom correlates closely with the World Bank’s measure of “voice and accountability” at the country level.
A key challenge, whereby richer countries, based on gross national income per capita, have higher SDG scores.
Taking SDG scores at face value then becomes effectively punitive to poorer countries, even those doing the right thing. This would be counterproductive from an investment perspective and from the ethos of sustainability. It would essentially reward countries who have benefitted from their historical industrial revolution and penalise those yet to go through theirs. It is key to support ‘improvers’, countries progressing, but which may not have strong realised SDG scores.
We group countries into four income brackets – high, upper-middle, lower-middle and low income – then compare SDG progress for countries of a similar level of development. We can then exclude the real laggards, while variation in SDG scores within each bracket allows for differentiation.
Engagement is the elephant in the room
Engagement is more complicated in the sovereign space, but still critical. It involves multiple stakeholders, from government officials and independent public agencies to non-issuer stakeholders, including supranational organisations, credit rating agencies, and other industry bodies.
Debt management offices are a useful avenue for engagement, particularly around ESG bond issuance. Another is contributing to the policy and regulatory debate through collaborative industry-wide groups. Further dialogue with governments would mark progress.
Sovereign fixed income is not confined to government bonds. Certain areas may have been somewhat overlooked, one being supranational institutions.
These are institutions owned by governments of multiple countries and are involved in various activities. They notably include regional development banks, which have for many decades been financing sustainable economic and social development. Underlining their role, we have seen recent EU bond issuance focused on fighting climate change, improving and protecting biodiversity and promoting gender equality. As important as their sustainable credentials, these entities currently offer an attractive additional source of return given the recent rises in interest rates and yields.
We recognise the questions and challenges around sovereign fixed income investment and sustainability and that this area is continually evolving. Sustainability is never going to be ‘one size fits all’, but ESG can be integrated with a clear and credible framework.
Bond valuations look attractive and investors remain resolutely focused on ESG. This could be an ideal moment to forge a stronger link between these two areas.
We hope so, because for us, not only is ESG undoubtedly compatible with sovereign investing, we are confident it can make a considerable difference over time. The key will be engaging and partnering with clients to overlay their requirements on top of this type of analysis to create solutions that will continue to evolve over time.
Paul Grainger is head of global fixed income and currency and manager of Schroders sustainable bond fund and Marcus Jennings is a fixed income strategist at Schroders