Brandywine Global outlines its steps in incorporating Environmental, Social and Governance (ESG) factors into investment decision-making.
Another insight can be gleaned from the scatter plot: given a specific ESG score, a country’s interest-rate spread may be “high” or “low” relative to the model-specified relationship, also known as the fitted line. For example—and this suggests the investment opportunity— a country whose interest-rate spread is trading well above that specified by the model. There is the potential for a mean reversion opportunity. A country with a yield spread “above” what its ESG score might suggest could be expected to compress. However, this simple equation isn’t sufficient to draw this conclusion. The investment case would have to be bolstered and validated by in-depth country and business cycle analyses. But, the ESG score helped identify investment potential. Now let us take the step forward.
We have added two governance scores, the World Bank’s governance effectiveness and the government (G) score from our third party governance component. The advantage of using our G is that it captures more than just governance, but adds political risk and ease of doing business measures. This is the twist that HSBC added to its sovereign scoring framework, the governance factor.
Now we create a composite score. Unlike the HSBC analysis, we decided not to weight the factors for now, believing more work is needed to divine the applicable factor weights. Second, we simply summed the variable rankings to create a composite score. Note there are two composite scores, one that includes just government effectiveness and the other a more comprehensive governance indicator. The country rankings between the two composites differ. This raises the question of which composite ranking is best, particularly in explaining a country’s risk. We tested this econometrically, running separate regressions for each composite. For the risk measure we used credit default swaps (CDS).
Sources: Brandywine Global, Bloomberg, Haver Analytics and Macrobond. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
ESG and Sovereign Bonds: Step by Step
- Consider adding social and environmental factors to the scoring framework. Earlier research has shown these components to offer less explanatory value, since these forces tend to act on economies over longer periods of time and the data frequency is limiting.
- A variable weighting scheme needs to be developed. We would expect some variables to be more important than others.
- A history needs to be created. Our overview here focused on a point in time, but it is important to know how these variables change over time, whether there is improvement or deterioration. Is there predictive potential?
- Increase the country coverage of this analysis. For this review we just looked at a subset of emerging market countries. Taking a cue from HSBC’s analysts, we need to add other countries, both emerging market and developed market economies—taking one step at a time.
The International Monetary Fund (IMF) is an international organization of various member countries, established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
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