Identifying countries’ ESG risks and opportunities
We believe investing effectively in sovereign debt requires in-depth analysis of environmental, social and governance (ESG) matters, especially in emerging markets. However, most ESG analysis and research focuses on corporates – not countries.
Therefore, in 2018 we built a proprietary model to help us better understand the ESG risks at the country level across our portfolios.
The benefits of new impact ratings
This year, a major development in our model has been the introduction of a new impact rating, which means that Insight’s country sustainability risk model now generates two complementary measures to give our portfolio managers greater insight over long-term trends:
- Risk rating: This provides a current snapshot of a country’s exposure to, and management of, ESG risks that may affect their overall creditworthiness.
- Impact rating: This provides a current snapshot of a country’s progress with regard to ESG factors aligned with the United Nations Sustainable Development Goals (SDGs).
The introduction of the impact rating can help to differentiate between those countries most likely to achieve the UN SDG targets, and those at risk of failing to do so.
By splitting our sovereign ESG framework into two models we can better tailor portfolios to client preferences, allowing for a greater focus on credit risk or impact and sustainability, as required.
Some insights from the model results
The insights from the sovereign ESG ratings provide a starting point for further analysis for our analysts and portfolio managers. Here are some examples:
- Countries with higher GDP per capita typically have better ESG scores. This is generally driven by governance and social factors, not environmental scores
- More countries are deteriorating on ESG than improving – with the majority of developed markets receiving a negative ESG momentum score
- ESG momentum has a weak relationship overall with standard industry measures of sovereign credit risk, but there are outliers
The difference our third-generation sovereign ESG framework makes in practice
Oliver Williams, Portfolio Manager in Insight’s Emerging Market Debt Team, explains how the framework highlights risks and opportunities in practice for our portfolio managers.
Q. How are the sovereign ESG risk ratings integrated within your investment process?
The ratings are now fully embedded within our emerging market debt sovereign analysis. It throws up a lot of red flags if a sovereign has a below-average ESG risk rating, or no positive momentum. We need to make sure we are being compensated for the risk embedded within the debt.
Q. Can you offer an example of how the ratings have driven investment decisions?
A recent example is El Savador, which has an overall Prime sovereign risk rating of 4, and a governance rating of 5, with no signs of improvement [1 is the best possible rating, 5 the worst possible rating].
These ratings helped to highlight for us the significance of the legislative elections in February 2021: we feared that if the populist Nuevas Ideas party won a supermajority, it would remove any meaningful checks and balances on President Nayib Bukele’s power.
Given this, we sold out of El Salvador ahead of the election. Nuevas Ideas won a supermajority, and the bonds have underperformed since then. As things stand, valuations relative to peers in Central America have become more attractive, but we still do not believe they would compensate what we perceive to be the elevated risks.
Q. Have any of the ratings surprised you?
We have been struck that while a number of emerging market African countries have below-average ESG risk ratings – such as Ethiopia, Ivory Coast, Rwanda and Egypt – their momentum with regard to ESG risks is positive (see Table 1).
Notably, Kenya has an overall ESG risk rating of 4, and yet it is second in the world in terms of positive ESG risk momentum.
Table 1 – Top and bottom five countries, ranked according to the Prime sovereign ESG risk momentum score
|Country||Prime ESG risk momentum score (a higher score is better)||Prime sovereign ESG risk rating (scale: 1 to 5, where 5 is the worst)|
|Top 5 Prime sovereign risk momentum score|
|Bottom 5 Prime sovereign risk momentum score|
|Hong Kong SAR, China||-0.9||2|
Q. How do the impact ratings affect investment decisions?
How we apply the impact ratings in practice depends very much on how a specific client wishes to express their values within their portfolio.
Broadly speaking, we aim to help our clients achieve positive sustainability goals through a combination of investing in impact issuance (green, social and sustainable bonds) and investing in conventional issuance where we believe doing so can support their progress on a positive trajectory – informed by our impact ratings.
The new impact ratings therefore give us an even broader toolkit to help us partner with clients in pursuing positive sustainability goals alongside their financial targets.