In the last decade, sustainable and responsible investing have become more important and gained in popularity among investors. With global ESG assets in mutual funds and ETFs doubling in the five years to June 2020[1] and reaching almost USD 1.7 trillion by the end of 2020,[2] there is growing recognition that the financial system has a crucial role to play in the transition to a low-carbon and climate-resilient economy.
In a new publication entitled “Measuring and Managing ESG Risks in Sovereign Bond Portfolios and Implications for Sovereign Debt Investing”, EDHEC-Risk Institute, with the support of Amundi ETF, Indexing & Smart Beta, develops a formal framework for incorporating environmental, social and governance (ESG) criteria into risk management and investment decisions involving sovereign bonds.
The main objective is to assess whether it is possible to incorporate ESG constraints through a significant improvement of the portfolio ESG score without a substantial increase in absolute and relative risk budgets, or a substantial decrease in expected performance.
The authors of the study draw four major conclusions:
- Higher environmental scores for developed countries and higher social scores for emerging countries are associated with lower costs of borrowing for issuers and consequently with lower yields for investors.
- Negative screening leads to more diversified portfolios and lower levels of tracking error, while positive screening leads to higher levels of improvement of ESG scores, at the cost of an increase in absolute and relative risk budgets.
- A dedicated focus on absolute or relative risk reduction at the selection stage allows investors to reduce the opportunity costs along the dimension that is most important to them.
- ESG momentum strategies in sovereign bond markets can be used to further reduce some of the aforementioned opportunity costs.
The results suggest that sound risk management practices are critically important in allowing investors to incorporate ESG constraints into investment decisions at an acceptable cost in terms of dollar or risk budgets.
Specifically this research confirms that improvement of the ESG attributes of sovereign bond portfolios comes at a measured cost in terms of active risk, and that ESG momentum strategies can reduce opportunity costs. Ultimately this validates ESG as a significant risk management tool in sovereign bond analysis.
Commenting on this research, Lionel Martellini, Professor of Finance at EDHEC Business School and Director of EDHEC-Risk Institute, said “This paper contributes to the ESG-investing literature on the importance of ESG considerations across asset classes by exploring the impact of ESG factors on the risk and return of sovereign bonds from an investor perspective and, in particular, investigating how to measure and manage EGS risks in sovereign bond portfolios and their implications for sovereign bond portfolio strategies.”
Commenting on the results of the survey, Laurent Trottier, Global Head of ETF, Indexing and Smart Beta Management at Amundi, said “Supporting EDHEC-Risk on this research harnesses Amundi’s expertise in fixed income indices and leadership in sustainable investing. As passive investors increasingly seek to incorporate ESG into their fixed income allocations, this research identifies important practical implications which address sovereign bond investors’ need for a more systematic approach to determining their exposure and the potential investment risk of ESG factors.
You can access an exclusive 2-page summary of the publication outlining the authors’ main insights here: https://risk.edhec.edu/measuring-and-managing-esg-risks-sovereign-bond
You can access the full publication here: “Measuring and Managing ESG Risks in Sovereign Bond Portfolios and Implications for Sovereign Debt Investing”.
This research was supported by Amundi as part of EDHEC-Risk Institute’s “ETF, Indexing and Smart Beta Investment Strategies” research chair.
