The challenge of integrating ESG into sovereign fixed income
- Sovereign bonds are the largest asset class for life insurers. They are also an essential source of long-term financing for public infrastructure projects. Yet a thorough analysis on how to integrate ESG consideration into investment decisions is lagging relative to equity and corporate credit.
- The current approach, based on excluding/weighting countries into sovereign bond portfolios given ESG scores averaging several metrics, has been shaken by the war in Ukraine. Russia's relatively high pre-war weight in sustainable indexes and its hasty exclusion highlight inherent problems with ESG scoring.
- ESG considerations matter more for Emerging Markets (EMs), where performance in terms of sustainability indicators is much more diverse than in Advanced Economies. Crucially, the most widely used ESG scores strongly correlate with per capita income. Therefore, their use for portfolio construction risks hurting the funding of developing countries, which most need financial resources to improve their environmental and social performance.
- We suggest an innovative approach to address the income bias in ESG scores. We show that a more balanced ESG weighting comes at no cost in terms of performance. We find that the redistribution of investments towards better ESG sovereigns should not penalise total return.
- Do financial markets care about sustainability? The evidence of pricing climate risk into sovereign spreads is mixed but slightly stronger for EMs. Moreover, bonds issued to fund environmental and social projects enjoy a small premium relative to standard ones.