integrating esg into sovereign bond portfolios - s&p global...utkarsh agrawal index research &...

CONTRIBUTORS

Julia Kochetygova

Senior Director

Global Equities & Strategy

[email protected]

Utkarsh Agrawal

Index Research & Design

[email protected]

Rikkert Scholten

Portfolio Manager of Fixed Income

Robeco

[email protected]

Johan Duyvesteyn

Senior Researcher

Investment Department

Robeco

[email protected]

Vishal Arora

Director

Fixed Income Research & Design

[email protected]

Guido Giese

Head of Indices

RobecoSAM

[email protected]

April 2015

Integrating ESG into Sovereign Bond Portfolios SUMMARY

Market-value-weighted portfolios give more weight to riskier issuers, e.g., those that issue more debt.

Environmental, social, and governance (ESG) weighting is an alternative way to construct a portfolio that looks at the sustainability of a country with a view focused on the long term.

ESG weighting has shown, in the cases of Greece, Spain, and Italy, that it may recognize early on that a country’s economic position is not sustainable.

INTRODUCTION

Credit ratings serve as the bedrock of the information that feeds investment decisions in fixed income analysis. They help us in evaluating the creditworthiness of the debtor. Although credit ratings are a useful tool, analysis could become challenging when bonds or countries have similar ratings or an investor is looking at investments with lower ratings. In such cases, it becomes essential to review additional risk parameters.

In this paper, we discuss how the idea to incorporate sustainability as a dimension of credit analysis can be implemented in the form of an additional, risk-reducing tool. This is based on the notion that sustainability, also known as the ESG performance of a country (not just a company), is an important element of a country’s long-term risk profile. In certain areas, sustainability overlaps with credit analysis, but it largely focuses on items that are either longer in their time horizon than the traditional credit assessment or more qualitative in nature. At the same time, these longer-term items can often lead to substantial macroeconomic consequences. An example of this could be a country’s dependency on external energy sources, which can lead to it being extremely vulnerable to changes in the price of oil.

Renewable energy generation, when measured as a percentage in the energy mix, can reflect the economic ability to innovate and benefit from low-carbon trends. Clearly, such ability to innovate is also a function of political will, which is hardly assessable in any other framework. The quality of water and water withdrawal as a percentage of available water resources is another important indicator, particularly when we think of countries with substantial areas exposed to drought. On the social side, the Human Development Index (HDI) serves as an indicator of a country’s potential to address long-term technological and economic challenges via the employment of human capital with necessary skills and habits.

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Integrating ESG into Sovereign Bond Portfolios April 2015

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The value of the HDI in a simple form can be computed from life expectancy and educational indicators. However, it can also be analyzed in combination with social unrest data, for example, which gives it more predictive power. Governance risks, like political uncertainty and the capability to implement reforms, have shown to be important for investment decisions during recent crises in emerging economies and in the eurozone. The matter of an aging population can also be seen as not only an immediate threat to the state finances via the pension system deficit, but it also poses a number of other challenges, such as necessary economic restructuring and the age-related change in the educational and electoral agenda.

RISK-REDUCING INDEXING

In the fixed income market, most index families are weighted according to the outstanding debt of the issuers and, consequently, the index is biased toward more indebted issuers—this indirectly implies higher risk. During the European debt crisis of 2009, the investors in these indices were overexposed to highly indebted countries, such as Greece or Italy, which led to a higher volatility of returns.

Consequently, the market is searching for efficient and low-cost investment solutions that would incorporate investment risks in an accurate way, and methods to measure these solutions. With this in mind, S&P Dow Jones Indices has constructed smart beta indices, which use modified weights of securities by incorporating risk-reducing parameters based on the type of risk one wants to reduce. The S&P ESG Pan-Europe Developed Sovereign Bond Index is based on the previously mentioned philosophy, and it incorporates ESG risk into its framework. The ESG risk is measured by RobecoSAM’s country sustainability ranking. The higher the RobecoSAM sustainability grade of a country, the lower its potential exposure to critical, country-level risks.

COUNTRY SUSTAINABILITY GRADE

RobecoSAM has developed a robust country sustainability assessment framework.1 The analysis of countries’

strengths and weaknesses with respect to a broad selection of ESG factors, and the resulting country scores, are produced on a semiannual basis; these scores offer a view into a country’s underlying change drivers and give investors insight into the potential dynamics of such change. Over 250 data points are evaluated—some developed in-house and some sourced from the reputable international organizations such as the United Nations, Organization for Economic Cooperation and Development (OECD), World Economic Forum (WEF), EIRIS, etc. The data points are grouped into 34 subindicators, which are again grouped into 17 indicators. These 17 indicators belong to an environment, social, or governance category.

In RobecoSAM’s ESG country assessment, the biggest weight is assigned to governance criteria. Cleary, the quality of state institutions and the reliability of a country’s political system will define the level of accountability of its government, its fiscal discipline, and its capability of driving relevant change. Items such as competitiveness, liberty & inequality, and political risk, as well as issues related to combating the aging of the population, drive the assessment of this component. RobecoSAM assigns scores to each of these criteria and uses them to calculate a country’s sustainability score. Sustainability scores are calculated for around 60 countries, covering both developed and emerging markets.

A combination of the sustainability score and the change in score is called the country grade. A ratio of 75% to 25% has been chosen for the score and change in score, respectively. This combination makes it possible to incorporate persistence in sustainability performance as part of a country’s ESG risk improvement. Moreover, the country grade can be used to depict the changes in a country’s profile. This is an important feature of the grade. Countries that demonstrate the capability to improve will be more likely to attract new investors to their bond markets—possibly at the expense of countries that already have quite high scores. The country grade will capture these trends and opportunities.

1 RobecoSAM’s Country Sustainability Ranking Methodology.

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S&P ESG PAN-EUROPE DEVELOPED SOVEREIGN BOND INDEX

The S&P ESG Pan-Europe Developed Sovereign Bond Index is the world’s first sovereign bond index with a sustainability overlay. This index uses the RobecoSAM grades of Pan-European developed countries for index construction.

Most developed countries in Europe have quite high sustainability profiles and, hence, the range of grades is relatively narrow, ranging from 6 to 8 on a 1-10 scale (1 – bottom, 10 – top). The average as of September 2014 was 6.70. The sustainability grade is compared with the average of the index universe, and the percentage point difference from the average is used to determine the weight adjustment. This makes it possible to adjust weights all the way to zero for the lowest-graded countries in the universe. As the Pan-European developed universe contains countries like Sweden and Germany, which have high grades, the improvement in the sustainability profile is obviously more limited.

Re-weighting of countries, and therefore, of all the securities of specific countries in the index, is done proportionally to the deviation of a country’s grade from the average grade. All the countries that are graded better than the index average will be overweighted in the index, while all countries graded lower than the index average will be underweighted. This means that the wider the distribution of the grades, the bigger the redistribution from the country’s original weight will be.

Although the average ESG grade of the countries in the Pan-European developed universe is between 6.70 and 7.20, which is quite a narrow range, it is still an important change, as it shifts the focus of the index toward the best-graded countries. This presents an interesting example for three reasons.

First, this universe contains the countries with the best ESG profiles. RobecoSAM has identified Sweden, Switzerland, and Norway as the top three in the world for country sustainability.

Second, the biggest appetite for sustainability products is in Europe, which means that this concept has the potential to resonate not only with traditional fixed income investors, but also with those who are driven by sustainability mandates and have not invested in sovereign bonds before. Therefore, it presents an interesting opportunity to test the degree of traction this type of investment strategy would generate from the investor community.

Third, Europe is where the most recent financial turmoil was happening due to country risks related to country sustainability; the weaknesses of the governance in Greece, and subsequently in other countries, have led to drastic financial consequences for the whole European financial system, which has presented a threat to the existence of the euro as a common currency. The ESG tilting of the sovereign bond portfolio would have helped to reduce the weight of the more risky countries during the crisis.

Performance Evaluation

The back-tested history of the S&P ESG Pan-Europe Developed Sovereign Bond Index provides some interesting results. In Exhibit 1, we can observe that the level of risk-adjusted returns for this index over a longer time period is higher and the annualized volatility is consistently lower in comparison to the underlying universe.


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Exhibit 1: Performance Indicators

Period S&P ESG Pan-Europe Developed Sovereign

Bond Index (USD) S&P Pan-Europe Developed Sovereign Bond Index (USD)

Annualized Returns (%)

1-Year -0.12 -0.15

3-Year 3.59 4.87

5-Year 3.09 2.39

Since May 2008 2.43 1.90

Annualized Volatility (%)

1-Year 5.50 5.85

3-Year 6.48 7.37

5-Year 8.50 9.52

Since May 2008 10.29 11.07

Risk-Adjusted Returns

1-Year -0.0215 -0.0256

3-Year 0.5529 0.6602

5-Year 0.3635 0.2509

Since May 2008 0.2359 0.1719

Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, 2014. Past performance is no guarantee of future results. The table is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

The correlation of monthly returns between the S&P ESG Pan-Europe Developed Sovereign Bond Index and the S&P Pan-Europe Developed Sovereign Bond Index was 98% from May 2008 to December 2014 (see Exhibit 2). While the return profiles of both indices show a close resemblance, there are important differences as well. The dynamic adjustments in the weightings would have made it possible to achieve similar returns as the original index, but with less risk. Exhibit 3 shows the monthly total return index values from April 30, 2008, to Dec. 31, 2014.

Exhibit 2: Correlation of Monthly Returns Between the S&P ESG Pan-Europe Developed Sovereign Bond Index and the S&P Pan-Europe Developed Sovereign Bond Index

Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, 2014 and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Chart is provided for illustrative purposes. Past performance is no guarantee of future results. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Y = 1.066X - 0.001 R² = 98.1%

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Exhibit 3: Total Return Index Values

Source: S&P Dow Jones Indices LLC. Data from April 30, 2008, to Dec. 31, 2014. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

The ability of the index to account for early signs of problems at a country level has been observed in the historical performance. Exhibits 4, 5, and 6 show the historical weights of Greece, Italy, and Spain in the S&P ESG Pan-Europe Developed Sovereign Bond Index and the S&P Pan-Europe Developed Sovereign Bond Index. At the same time, the S&P ESG Pan-Europe Developed Sovereign Bond Index has been able to keep up with most positive returns in European government bond markets after 2012 by investing more in other countries, like the U.K.

Exhibit 4: Historical Weight of Greece

Source: S&P Dow Jones Indices LLC. Data as of Jan. 1, 2015. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

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Exhibit 5: Historical Weight of Italy

Source: S&P Dow Jones Indices LLC. Data as of Jan. 1, 2015. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Exhibit 6: Historical Weight of Spain

Source: S&P Dow Jones Indices LLC. Data as Jan. 1, 2015. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

The weights of Greece, Spain, and Italy have consistently been lower in the S&P ESG Pan-Europe Developed Sovereign Bond Index than in the S&P Pan-Europe Developed Sovereign Bond Index. Greece’s weight was actually brought close to zero far before the country’s problems surfaced. This highlights the potential benefits of investing in an ESG-tilted index. We can also visualize the effect of the ESG profiles of other countries on the ESG index; Exhibit 7 shows how the most recent scores and their dynamics materialize in the weights of countries in the ESG-tilted index compared to its parent index. Exhibits 8 and 9 show the historical weights of all the countries in the S&P ESG Pan-Europe Developed Sovereign Bond Index and in the S&P Pan-Europe Developed Sovereign Bond Index, and how ESG grades affect country weights.

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Exhibit 7: Weights by Country

Country S&P ESG Pan-Europe Developed Sovereign Bond

Index (%) S&P Pan-Europe Developed Sovereign Bond

Index (%)

Austria 3.5 2.9

Belgium 3.2 4.6

Denmark 1.7 1.3

Finland 1.1 1.1

France 14.6 17.4

Germany 19.5 15.0

Ireland 1.7 1.4

Italy 9.0 17.8

Luxembourg 0.1 0.1

The Netherlands 4.2 4.7

Norway 1.0 0.5

Portugal 0.6 1.3

Spain 4.4 9.2

Sweden 2.1 0.9

Switzerland 2.1 1.1

UK. 31.1 20.6

Source: S&P Dow Jones Indices LLC. Data as of Jan. 1, 2015. Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

Exhibit 8: Historical Weights in the S&P ESG Pan-Europe Developed Sovereign Bond Index

Source: S&P Dow Jones Indices LLC. Data as of Jan. 1, 2015. Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical information for the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

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Switzerland

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Spain

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The Netherlands

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Italy

Ireland

Greece

Germany

France

Finland

Denmark

Belgium

Austria


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Exhibit 9: Historical Weights in the S&P Pan-Europe Developed Sovereign Bond Index

Source: S&P Dow Jones Indices LLC. Data as of Jan. 1, 2015. Past performance is no guarantee of future results. Chart is provided for illustrative purposes.

We can see that the weight of countries like the U.K. in the S&P Pan-Europe Developed Sovereign Bond Index has steadily increased since its inception, reflecting the increase in its ESG profile.

Exhibit 10 displays the weighted ESG grade of the S&P ESG Pan-Europe Developed Sovereign Bond Index and its underlying index. The chart shows that historically, the weighted average ESG grade of the S&P ESG Pan-Europe Developed Sovereign Bond Index has been stable in comparison with its underlying index. In addition, as one would expect, the new index has a consistently better ESG profile than the original index. This depicts the advantages of the tilted weighting scheme used to incorporate the ESG analysis in the index.

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Germany

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Exhibit 10: Weighted ESG Grade

Source: S&P Dow Jones Indices LLC. Data as of Jan. 1, 2015. Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the S&P ESG Pan-Europe Developed Sovereign Bond Index. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance.

CONCLUSION

Incorporating ESG country risk metrics can help to better understand and potentially reduce risk in sovereign bond portfolios. The insights provided by the S&P ESG Pan-Europe Developed Sovereign Bond Index, which utilizes RobecoSAM country ESG grades, can help investors make decisions that optimize their portfolio on the efficient frontier by diversifying their investments.

Although the room for improvement in the ESG profile of the index in the Pan-Europe developed market is somewhat limited due to the already high level of country scores in this investment universe, incorporating the ESG analysis may have potential benefits in the long run. These benefits could be especially significant in an environment where sovereign credit risk is high. Even more than the European experience, the emerging market’s sovereign bond story, with its frequent periods of risk aversion and diversion pricing of sovereign credit risk, may be a good example of this.

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PERFORMANCE DISCLOSURES

The S&P ESG Pan-Europe Developed Sovereign Bond Index was launched on March 26, 2015. All information presented prior to the launch date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect on the launch date. Complete index methodology details are available at www.spdji.com.

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Past performance of the Index is not an indication of future results. Prospective application of the methodology used to construct the Index may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the Index. Please refer to the methodology paper for the Index, available at www.spdji.com for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations.

Another limitation of using back-tested information is that the back-tested calculation is generally prepared with the benefit of hindsight. Back-tested information reflects the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities (or fixed income, or commodities) markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance.

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