As deficits skyrocket, bond investors have an opportunity to engage with governments to try to ensure they tackle climate change, argues Thomas Dillon.

Traditionally, ESG has been the preserve of equity investors. Although the global bond market is roughly 25 per cent bigger than the stock market, as of mid-2019, fixed income strategies made up only a fifth of all the assets of sustainable mutual.1

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.

Figure 1: ESG bond issuance ($ billion)
ESG bond issuance
Source: Aviva Bloomberg. Data as at March 3, 2021

However, this is finally changing as 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.

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.

The US would arguably score poorly on many ESG criteria

Take 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 engagement challenge

Engagement has long been used by equity investors to drive positive changes in companies. However, it is far less common between the owners and issuers of debt. A 2017 report by the Principles for Responsible Investment showed 58 per cent of signatories did not engage with sovereign issuers.2

Investors have an incentive to integrate ESG considerations into mainstream sovereign credit analysis

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, governments need to step up. 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 investors with an opportunity to engage more effectively.

The power of collective action

While some firms may feel they lack sufficient size to influence sovereign issuers’ behaviour, collaborative investor action can be highly effective.

Aviva Investors and like-minded investors engaged with the Brazilian government on its environmental practices

As an example, last year Aviva Investors collaborated with like-minded investors to engage with the Brazilian government on its environmental practices.

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.

Brazil subsequently announced a series of positive measures in response, including a 120-day moratorium on forest fires – an encouraging first step that hopefully provides a blueprint for further collaboration between investors.

Debt roadshows provide sovereign debt investors an opportunity to engage governments

Engaging with investors makes sense from the borrower’s perspective too. Debt roadshows provide 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.

Growing investor appetite for sustainable bonds also holds out the prospect of lower funding costs, which could improve the ability of countries to meet their climate pledges at the same time as mitigating future climate-related catastrophes.

Sustainable bond boom

While poorer countries tend to be more vulnerable to the effects of climate change, 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 in countries such as Japan, Germany, Australia and the US could present an opportunity.

According to data provider Refinitiv, sustainable bond issuance totalled a record $544.3 billion in 2020, more than double the previous year, with sovereign debt accounting for just over a quarter.

Just as investors seek to build diversified portfolios, from an issuer’s perspective a diversified investor base can mitigate the risk demand will be unduly affected by a particular group of investors.

Together, these developments help explain why even richer countries are starting to see the attraction of such 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 governments.

In September 2020, Germany attracted more than €33 billion of bids for up to €6 billion of green bonds.3 Italy recently sold €8 billion of debt, the biggest debut sovereign green bond from a European issuer,4 while in March the UK announced plans to sell at least £15 billion of green bonds later this year.5

The sustainable bond market looks to be ripe for further rapid expansion

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 at least that of the conventional bond, by purchasing green bonds if it falls below that level.

The market looks ripe for rapid expansion, especially with several countries contemplating big ‘green’ infrastructure projects. Sustainable debt is expected to make up around a third of the EU’s €750 billion 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.

Even the richest countries may find their debt harder to sell unless they take sustainability criteria more seriously

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.

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