Government bonds: evaluations increasingly informed by Responsible Investing criteria

by Dr Ingeborg Schumacher, Director, Responsible Investing, Kaiser Partner

Kaiser Partner has been using additional sources of information to analyze bonds for several years. Alongside traditional agency ratings, we incorporate analyses produced by an independent credit scoring and research institution. Issuers – whether corporate, supranational or governmental – are subjected to a detailed review of their environmental, social and corporate governance performance. The aim, of course, is to optimize the selection of issuers, and latest studies show that the application of sustainability criteria works for government bonds as well as corporate paper.

For a long time, Responsible Investing techniques seemed to be reserved for equity markets. Initially the “sin stocks” of ethically controversial companies were eliminated from consideration. Then the “best-in-class” approach was used to identify companies that scored best in their industry in terms of environmental and social factors. This could be done most effectively in the equities sector. Providers of sustainable investments could argue that by selecting forward-looking companies they were minimizing the risks for investors and simultaneously offering an incentive to companies, including those in controversial industries: if these companies wanted to be included in the portfolio, they had to make improvements.

Not least because insurance companies, pension funds and other institutional investors have become more active in the market, demand has grown for sustainability options in defensive asset classes too, including money market instruments and bonds. A study of the market by European sustainability association Eurosif showed that bonds overtook equities as the most popular instrument for responsible investing in 2009.

States can also be assessed on environmental and social criteria

This all means that fund managers now also have to apply environmental and social criteria when evaluating countries and supranational organizations as major issuers of bonds. The methods are not all the same as for the more familiar ESG assessments of private sector companies, but there is still a lot of publicly available information for analysts to work with. Fund managers at Zürcher Kantonalbank (ZKB), for example, look at a country’s resource and energy consumption, its level of greenhouse gas emissions and its ratification of international environmental accords. For the social side, they look at aspects such as income distribution, unemployment rates, spending on health and education, human rights violations, use of the death penalty, etc.

Another fund provider, Sarasin, examines indicators relating to the availability of resources and their efficient use. The availability of natural, social and economic resources is measured by quantifying a country’s mineral resources, tangible capital such as buildings and machinery, and physical infrastructure. Various forms of human capital (knowledge, labour, institutions) are also measured. Government bonds are essentially promises of future interest and amortization payments, so their fulfilment also depends on future tax revenues.

Sustainability criteria have proved effective as indicators

Sarasin sees sustainability criteria as early indicators to be used alongside traditional credit ratings when assessing the long-term strength of an economy, and it can prove that this approach has paid off in recent years. Among emerging markets, more sustainable countries have seen the value of their government bonds increase by a greater amount. Sustainable industrial countries have been less affected by the current debt crisis; and apart from a short and quickly overcome interruption, sustainable emerging economies have seen their government bonds perform better than those of their non-sustainable peers for many years. It is clear that countries hit by the debt crisis were living beyond not only their financial but also their environmental means: inefficient use of resources led to lower competitiveness overall, further exacerbated by rapidly ageing populations, corruption and large income differentials within the population. It also became apparent that the most influential criteria differed depending on the type of country: indebtedness, education and the environment were the most important factors for industrial nations, while emerging economies were most influenced by environmental, health, education and demographic factors.

The ZKB has also found that if countries fail to meet environmental and social criteria, they are likely to face additional credit risks that are not yet priced into their government’s bonds. Greece, for example, does poorly in the ZKB’s assessment because of its lax environmental policy, high youth unemployment and lack of support for the unemployed. ZKB’s analysts can show that sustainable states, especially those with a high social rating, often have a good credit rating too. The top group of sustainable countries all have the highest AAA credit rating. By contrast, countries that previously had good credit ratings, but poor sustainability scores, like the USA and Japan, have faced fundamental problems during the current crisis.

There is no doubt that a systematic analysis of default and loss risk using additional ESG criteria is a worthwhile element in any comprehensive assessment of credit risk.

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