Analysing sovereign, municipal and supranational issuers

While the investment processes for corporate and sovereign bonds may be similar, analysis of company and sovereign creditworthiness is markedly different – most obviously in terms of the criteria assessed. In addition to corruption, investors have identified a number of other ESG indicators that provide greater insight into creditworthiness.

• For more information on the links between ESG factors and sovereign creditworthiness, see Sovereign bonds: Spotlight on ESG risks.

In contrast to ESG analysis for listed equities, social factors tend to be given greater weight than environmental factors because of links between political stability, governance and a country’s ability to raise taxes or make reforms.

Key ESG criteria for sovereign bond analysis

ENVIRONMENTAL	SOCIAL	GOVERNANCE
Carbon intensity	Demographics	Institutional strength
Water stress	Education and health capital	Corruption
Energy resource and management	Health levels	Regime stability
Natural disasters	Political and press freedoms	Rule of law
Biocapacity and ecosystem quality	Human rights	Financial reporting
Pollution	Labour standards	Regulatory effectiveness
Biodiversity	Social exclusion	Adherence to conventions
Agriculture	Income inequality	International relations

Soveriegn issuers

Union Investment, a German investment manager, assesses corruption as a key indicator of sovereign credit strength because of the relationship between fraud, tax avoidance, financial mismanagement and an issuer’s ability to repay its debt obligations. There are strong correlations between corruption and the number of sovereign defaults.

French investment manager Oddo Securities uses the environmental indicators listed below as part of its sovereign credit analysis. Together, these constitute one-third of aggregated ESG scores. Based on performance relative to average ESG score in the group, countries are divided into four categories from ‘strong’ to ‘limited’ opportunity. Scores are relative, so they allow investment teams to identify potential investment risks and opportunities. For example, in its 2012 study, Oddo identified Sweden, Denmark and New Zealand as demonstrating the best management of ESG-related risks of all OECD countries. By comparing the relative ESG risks of certain sovereigns, their opportunities to improve those scores and current credit ratings, investors can identify potentially mis-priced securities.

Oddo Securities’s environmental criteria for governments (2012)

THEME	INDICATOR	SOURCE	WEIGHTING
Agriculture	Food self-sufficiency	FAO	1.0
	Arable land	FAO	2.0
Biodiversity	Endangered species	World Bank	2.5
Climate change/ Energy	Per capita energy consumption	World Bank/IEA	4.0
	Per capita CO2 emissions	World Bank	2.0
	Carbon intensity of growth	World Resources Institute (WRI)	2.0
	Energy mix	International Energy Agency	2.0
Water	Pressure exerted on water resources	Aquastat (FAO)	4.0
	Renewable water resources per capita	Aquastat (FAO)	4.0
Air pollution	Sulphur dioxide emissions	World Resources Institute (WRI)	2.0
Resources	Ecological footprint	Global Footprint Network	2.5
	Forests	Aquastat (FAO)	2.0
	Maritime Exclusive Economic Zone	Flanders Marine Institute (FAO data)	1.5
Transport	Sustainable mobility	Economic Commission for Europe (UN)	2.0
			33.5

Emerging market debt investors

Of those interviewed by the PRI, emerging market debt (EMD) investors gave more weight to ESG factors because of the insights they provide in place of reliable financial indicators. For Rob Drijkoningen, managing director and cohead of emerging market debt at US investment manager Neuberger Berman, becoming a PRI signatory spurred on his team’s efforts to develop an internal analytical framework that incorporates material ESG factors alongside economic indicators. Forty percent of its overall sovereign debt score comprises ESG; the remaining 60 percent is based on traditional financial metrics.

It “was fuelled by a desire to have a more structured approach,” says Drijkoningen. “We lacked a comprehensive framework on ‘soft’ factors, which have a huge overlap with ESG criteria.” The team started with a list of 40 or 50 indicators and shortened that to 15. It back-tested all of them, looking at a pool of 65 issuers over a 10-year period to find out which were most effective.

Turkey is cited as a country with good economic fundamentals but a deteriorating ESG score. “Some of the macro fundamentals have recently improved, but slow growth makes the current account deficit less sustainable, and politics are having an increasingly nasty impact now….that is showing up in how we rate them,” says Mauricio Vargas, economist at Union Investment. Rene Lichtschlag, EMD fund manager with Union Investment, adds, “We saw corruption, rule of law, political stability going south, while movement in the macroeconomic indicators was either neutral or positive. We therefore adjusted our exposure.”

“Argentina has over recent years persistently understated inflation levels. In fact, this issue dates back to 2007, when just as a sharp increase in inflation due to medical insurance was widely anticipated, data was unexpectedly withheld and the Board of the National Statistics Office replaced overnight – in itself raising clear governance concerns. During visits to the country, it has become abundantly clear to us that inflation is being considerably understated. As a result, we have applied a higher risk premium to Argentinian debt securities.”

Colonial First State Global Asset Management, Responsible Investment and Stewardship Report (2013)

Municipal issuers

Municipal or local government bonds can be divided into two categories: general obligation bonds backed by tax inflows and revenue bonds backed by revenues from a specific project such as toll roads. The US municipal bond (muni) market is currently at US$3.7 trillion of debt outstanding.6 The market is considered fairly stable, although default rates have increased considerably since 2008. The bankruptcy of the city of Detroit in 2013 was the largest in US history and served as a wake-up-call for many city employee pension funds.

The analysis of munis shares characteristics with corporate credit analysis; this applies for ESG analysis as well. For both general obligation and revenue bonds, governance and social factors will affect the issuer’s ability to raise revenues from taxes or other types of income. Important environmental criteria include the carbon intensity of a state’s energy production and the quality of public infrastructure such as wastewater treatment plants.

US-based Breckinridge Capital Advisors manages investments in corporate and muni bonds. It says the risk of default in the municipal bond market is higher when public opinion on a project is ambivalent with regard to public infrastructure such as stadiums and housing. Peter Coffin, president at Breckinridge, says, “The more focused a project is on something that’s core to the government’s providing for the education, health care and well-being of its citizens, the safer the bond is”.8 Breckinridge integrates ESG analysis to help determine the ‘essentiality’ of a municipal project or issuer, the expected support of the community and the quality of the issuer’s governance practices. Local unemployment rate, median household incomes and constituent education levels are used as indicators of long-term creditworthiness in this model.

Supranational issuers

Supranational organisations, such as the World Bank and the European Bank for Reconstruction and Development, regularly issue bonds to finance sustainable development–related projects and businesses. These organisations are considered relatively low risk and typically issue investment-grade bonds. As a result, ESG analysis on supranationals tends to be more focused on their use of proceeds than on the creditworthiness of the issuer itself. Supranational issuers act very much like banks in the way that they finance their projects, typically with long-term loans, by issuing bonds.

ESG analysis will give investors additional insights into these projects and help to ensure that issuers interests are aligned with those of the investors in these bonds. Many of these investments are made in emerging market economies where regulatory frameworks and transparency may be poor and certain risks less obvious as a result. In these cases, investors should ensure that the issuer has the capacity to identify and manage ESG risks, for example, by following the IFC’s Performance Standards or the Equator Principles. The list below contains more details on themed bonds issued by supranationals .

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