How did so many financial analysts, with so much information and technology at their disposal, fail to see the euro zone debt crisis coming, and what can be done to avoid such risks next time?

Sovereign bonds issued by developed countries had long been considered a safe haven for institutional investors’ assets. The euro crisis has reminded us that the debt of the highest-rated countries can be volatile. The PRI’s Sovereign Fixed Income Working Group set out to explore the use of environmental, social and governance analysis as a potential risk-reducing, return-enhancing tool when added to the traditional mix of fi nancial and economic data and political risk. The results of this exercise are presented here.

Section 1 looks at what’s at stake: the sheer size of the sovereign bond market and the stabilising role it has played in the portfolios of pension funds and other institutional investors. Though it is currently applied to only a small percentage of total assets under management, the use of ESG analysis is likely to grow. Institutional investors, stung by market volatility during the euro crisis or wary of diff erent risks and opportunities as they increased allocations to emerging markets, are increasingly demanding the application of ESG analysis to sovereign bonds as a criteria for appointing asset managers.

Academic and investor research highlighted in Section 2 shows correlations between ESG factors and credit risks, for example, corruption and sovereign bonds performance are clearly correlated. Moving to social factors, we see that a highly educated, IT-literate society paired with a repressive political system can increase the risk of political regime change. Egypt during the Arab Spring movement is a case in point. By looking at social and political factors, investors can build up a picture of a country, and better gauge the risks of investment. Finally this section asks why the market is failing to factor in major environmental risks, given mounting evidence of their importance.

The research and experience of working group members with regard to materiality, summarised in Section 3, indicates that ESG factors can be material to both creditworthiness and investment performance. Given these compelling results, the challenge to others is to act on the information that is increasingly available.

One of the most commonly debated items on the sovereign bonds agenda is the role of the credit rating agencies. Section 4 highlights what many working group members see as failings in the approach of these companies, and the opportunity to get them to incorporate ESG analysis. In discussions and interviews, the working group and rating agencies have both expressed the need for ESG data presented in a format they can apply. Service providers are rising to the challenge of providing reliable quantitative and qualitative information, as we discuss in Section 5.