Lean on me

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.

Figure 1: ESG bond issuance ($ billion)

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.

Regulatory hurdles

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.

The power of collective action

While some firms may feel they lack sufficient size to influence sovereign issuers’ behaviour, history has shown on many occasions in the corporate world that strength in numbers, through collaborative investor action, can be highly effective. Slowly, but surely, this approach is being applied to specific situations in the sovereign market.

As an example, last year Aviva Investors collaborated with like-minded investors to engage with the Brazilian government on its environmental practices. This included an open letter calling on it to reduce deforestation rates, enforce Brazil’s Forest Code tackling illegal logging, and improve public access to data to enable external monitoring.

With Brazil increasingly reliant on global capital markets to fund its budget deficit, this culminated in a series of high-level ministerial meetings, including with the Brazilian vice president and other influential legislators, attended by Aviva Investors’ chief investment officer.

Brazil subsequently announced a series of positive measures in response, including a 120-day moratorium on forest fires – an encouraging first step. Admittedly, the challenge around the lack of enforcement remains, with forest fires during peak season remaining at a decade-long high. Nevertheless, the process highlighted the role investors can play in engaging with sovereign borrowers on their sustainability practices. It also hopefully provides a blueprint for further collaboration between investors in the future.

To see why engaging with investors might make sense from the borrower’s perspective too, take the case of India. According to a report from the World Bank, India’s food security, water resources and health are all at risk from a warming climate. The Bank went on to say both Mumbai and Kolkata, two densely populated cities, are particularly vulnerable to the impacts of sea-level rise, tropical cyclones, and riverine flooding. Mumbai has the world’s largest population exposed to coastal flooding, with much of it built on reclaimed land, below the high-tide mark.⁴

Even in the case of a country as big as India, any unilateral action is not going to make a huge difference to climate change. Nonetheless, debt roadshows provide sovereign debt investors an opportunity to engage governments, point out climate change poses an investment risk, and ascertain the steps they are taking to meet their international commitments.

To date, only a handful of countries have issued green bonds, with supply having overwhelmingly come from corporate issuers. However, growing investor appetite for green bonds, and other categories of sustainable debt, holds out the prospect of lower funding costs, which could improve the ability of a nation such as India to meet its climate pledges at the same time as mitigating future climate-related catastrophes.

Extreme weather events

While poorer countries tend to be more vulnerable to the effects of climate change, it is important to remember many richer ones remain among the world’s biggest polluters. Although investors may consider themselves to be in a weaker position to engage with them, the apparent rise in extreme weather events in recent years could present an opportunity as it indicates few countries are likely to be spared.

In 2018, Japan witnessed the strongest typhoon in a quarter of a century, leaving 14 dead and resulting in insured losses estimated at up to US$14 billion. The same year, a sustained summer heatwave and drought, along with average temperatures nearly three degrees Celsius above normal over a four-month stretch, resulted in 1,250 premature deaths in Germany and losses of $5 billion, mostly in agriculture.

In 2019-20, a devastating series of bushfires in Australia burnt an estimated 18.6 million hectares, with economists estimating the cost at over A$103 billion in property damage and economic losses, making it the country’s costliest natural disaster to date. Months later, the largest wildfire season in California's modern history (according to the California Department of Forestry and Fire Protection) burned roughly four per cent of the state’s land, destroyed over 10,000 structures and cost over $12 billion.⁵

Green mushrooms

As central banks and other regulatory bodies attempt to mobilise capital for green and low-carbon investments in the broader context of environmentally sustainable development, and with ESG bond indices springing up, investor demand for debt linked to ESG factors is surging. According to data provider Refinitiv, issuance of sustainable bonds totalled a record $544.3 billion in 2020, more than double the previous year, with sovereign debt accounting for just over a quarter of this total.

Just as investors seek to build diversified portfolios, from an issuer’s perspective a diversified investor base can mitigate the risk that demand will be unduly affected by the behaviour of a particular group of investors. That is why issuers tend to sell a wide range of securities: bonds with fixed and floating coupons, different maturities, and denominated in different currencies.

Together, these developments help explain why even richer countries are starting to see the attraction of issuing ‘green’ bonds; they provide funding for environmental projects and require borrowers to report to investors on how the funds are used. The green sovereign bond market has mushroomed in recent years, especially in Europe, providing investors with a further opportunity to engage government borrowers.

In September 2020, Germany attracted more than €33 billion of bids for up to €6 billion of ten-year green-labelled debt. Since the issue will help establish a benchmark for pricing other green transactions, many see the sale as a landmark step in the development of Europe’s green bond market.⁶ Italy recently sold €8 billion of debt, the biggest debut sovereign green bond from a European issuer to date,⁷ while in March the UK announced plans to sell at least £15 billion of green bonds for the first time later this year.⁸

Germany’s green bonds are to be “twinned”, meaning investors will be able to swap their green bonds for the conventional equivalent at any time. The finance ministry says it will seek to ensure the price of the green twin is always at least that of the conventional bond, by purchasing green bonds if it falls below that level. Its move is designed to allay fears smaller, less liquid green securities would trade at a lower price.

The market looks to be ripe for further rapid expansion, especially with several countries contemplating big ‘green’ infrastructure projects to help navigate their way out of the current crisis. Sustainable debt is expected to make up around a third of the EU’s €750 billion COVID recovery fund over the next five years. As for the US, there is speculation it could issue its first green bond, perhaps in the run up to November’s COP26 summit, as a further signal of President Joe Biden’s determination to tackle climate change.

No quick fix, but the signs are promising

More and more issuers are becoming aware of the need to ensure their communications with investors incorporate ESG factors. The emergence of sustainability-linked debt – where the terms of an issue are contingent on the attainment of various sustainability targets by the borrower – is another recent trend.

The challenges that have historically impeded engagement with sovereign issuers are not going to disappear overnight. That is partly because the option to divest from the safest and most liquid markets is often not available. But as ESG factors take on ever more significance, even the richest countries may find their debt, at the margin, harder to sell unless they take sustainability criteria more seriously.