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

Summary:

This study, “Measuring and Managing ESG Risks in Sovereign Bond Portfolios and Implications for Sovereign Debt Investing" demonstrates that implementation choices regarding how ESG constraints are incorporated in the context of sovereign bond portfolio construction have a material impact on this opportunity cost. In particular, we find that 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. We also confirm that negative screening leads to more diversified portfolios and lower levels of tracking error, while positive screening leads to higher levels of improvement of ESG scores, at the cost of an increase in absolute and relative risk budgets. In an attempt to alleviate some of these concerns, we 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. Finally, we provide evidence that ESG momentum strategies in sovereign bond markets can be used to further reduce some of the aforementioned opportunity costs. Overall, our 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.