Country-based environmental, social and governance (ESG) analysis could identify winners and losers in the sovereign bond universe, new research from Brandywine Global suggests.
The study by Brandywine Global senior vice president investment research, Patrick Bradley, found a link between ESG rankings and sovereign bond risk as measured by credit default swap (CDS) rates.
Brandywine Global created two composite sovereign bond scores with one covering “just government effectiveness and the other a more comprehensive governance indicator”.
Using both ESG and standard financial data sourced from the World Bank, HSBC and in-house research, the study found the comprehensive governance model provided the ‘best fit’ against five-year CDS rates for 15 emerging market countries.
“The above model could be used to identify potential long or short positions, and investments where interest-rate compression could occur,” the report says. “That would be a return-generating investment for a sovereign bond investor.”
In particular, current Russian and Brazilian CDS rates were much higher than average compared to the Brandywine Global composite measure suggesting “an opportunity for CDS to fall”.
“… CDS and interest-rate spreads are highly correlated,” the report says.
While the study found ESG analysis shows some promise as a new tool for sovereign bond investors, the Brandywine Global report says the framework needs further work including:
- potentially adding social and environmental factors to the scoring system – albeit that these two parameters “offer less explanatory value” than governance;
- developing a robust weighting system for the factors used by the model;
- building a deeper historical research record to see how the factors have varied over time; and,
- adding more countries to the data set beyond the 15 emerging market jurisdictions covered by the Brandywine Global study.
In a study last year, the BNY Mellon funds management business, Insight Investment, rated NZ as the most sustainable sovereign bond market as measured by a new bespoke ESG scoring method. The Insight Investment research ranked 186 countries on broad ESG factors to provide a risk framework for sovereign bond investors.
At the time, Insight’s Australia and NZ head, said the “proprietary ratings and momentum scores complement our existing tools for evaluating sovereign and sovereign-related debt”.
“Insight has shown that building a country sustainability risk model not only is possible and credible but can complement and reinforce traditional evaluations of sovereign issuers,” Murphy said.
Brandywine Global, part of the Legg Mason stable of managers, is best known in NZ for its unconstrained fixed income Global Opportunities Fund, which has attracted over $800 million from local investors.
Colin Taylor, Legg Mason Australasia head of sales, said investors were increasingly looking for ESG solutions across asset classes, rather than simply focusing on equities.
“ESG factors have been vital inputs into our risk assessments for all of our global bond markets,” Taylor said.