Measuring and Managing ESG Risks in Sovereign Bond Portfolios and Implications for Sovereign Debt Investing

Abstract

This article shows that implementation choices matter with respect to how environment, social, and governance (ESG) constraints are incorporated in sovereign bond portfolio construction. In particular, the authors confirm that negative screening leads to more diversified portfolios and lower levels of tracking error, whereas positive screening leads to higher levels of improvement of ESG scores, at the cost of an increase in absolute and relative risk budgets. The authors also find that 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. Overall, the results suggest that sound risk management practices are critically important in allowing investors to incorporate ESG constraints in investment decisions at an acceptable cost in terms of dollar or risk budgets.

TOPICS: ESG investing, fixed income and structured finance, global markets, portfolio construction

Key Findings

• ▪ 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.

• ▪ A minimum variance optimization approach leads in general to better performance compared to a negative screening strategy for the same level of E, S, and G score improvements.

• ▪ ESG momentum strategies generate additional value, suggesting the presence of some form of underreaction to news related to changes in ESG scores.