(Bloomberg) -- Lending money to governments with questionable human rights records can hurt investors’ returns as well as their ethics, according to risk-analytics firm Verisk Maplecroft.
The best-performing countries on human and labor rights have significantly lower bond market spreads compared to the worst, even when taking into account factors such as level of income, it said in a report based on six years of its ESG data. That chimes with the benefits nations get from moving toward a low-carbon economy, with the most advanced enjoying pricing 13% lower than the worst, it said.
The findings suggest ESG risks are increasingly feeding through into sovereign bond pricing independently of credit rating scores and other factors. While the market for ESG debt has exploded, applying sustainability criteria to nation states issuing conventional bonds is still a nascent practice.
“Sovereign investors can and should explicitly take social factors into account,” Verisk Maplecroft analyst David Wille and head of markets James Lockhart Smith wrote in the report. “Many investors have doubted the materiality of the S in ESG because traditional assessments of social risks did not show an independent statistical relationship with bond pricing.”
Funds under regulatory and client pressure to clean up their portfolios are pouring money into ethical debt, yet at around $4 trillion that’s still a fraction of the total government bond market. It has been slow to adapt to ESG concerns relative to stocks, since frameworks designed to evaluate corporations don’t easily translate into analysis of nation states.
ESG scores for countries, where they exist, have been criticized for being correlated to a nation’s wealth, potentially penalizing poorer countries. Verisk Maplecroft on Thursday launched its own sovereign ESG ratings as well as an additional set of income-adjusted scores that aims to address this problem. The back-dated versions of these form the basis of the research.
The entry by the firm, well known for analyzing country risk, into ESG ratings underlines growing investor demand for insights into how to approach sovereign debt in ethical portfolios. The more established market for corporate ESG scores, from the likes of MSCI Inc. and Sustainalytics, is beginning to attract regulatory scrutiny.
A one-notch improvement in an issuer’s social rating is associated with bond spread tightening of nearly 4%, similar to governance ratings and more than for environment, Verisk Maplecroft found. A one-notch upgrade in its overall ESG rating is linked to a larger cut in bond spreads than “equivalent credit rating upgrades,” it said.
The integration of social and environmental issues into market pricing is a recent phenomenon. Verisk Maplecroft research from 2019 found markets were at best ignoring and at worst actively penalizing governments making the most progress away from fossil fuels.
“Environmental risk is probably the least material in the shorter term but most devastating in the longer-term,” said Lockhart Smith in an interview. There is now “a value-based case” for incorporating ESG into sovereign debt, he said.
(Adds details on ESG ratings market in seventh paragraph.)
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