ESG and Sovereign Bonds: Step by Step

Around the Curve

ESG and Sovereign Bonds: Step by Step

Brandywine Global outlines its steps in incorporating Environmental, Social and Governance (ESG) factors into investment decision-making.


Environmental, Social, and Governance (ESG) factors have increasingly become a part of investment research efforts, whether the focus is equities, corporate bonds, or sovereign bonds. Investor interest continues to grow as well. ESG’s impact on investments is gaining traction. The information void continues to be filled and investment managers have increased efforts to develop research that integrates these factors into their investment processes. Rating agencies are increasingly focused on such factors, particularly the impact of governance on sustainable growth. The International Monetary Fund (IMF) has indicated that governance “is key to economic success.” We continue to advance our efforts as well.

Step Back

We introduced our systematic approach to incorporating ESG factors into the sovereign bond research process in September 2017, in our first related blog entry: ESG: Seeds Are Sprouting. In that blog we noted that we applied third party metrics. Those metrics included a number of ESG variables. Individual scores for each component were generated, and then combined to produce an overall ESG score. A high ESG score revealed a country that ranks highly across several factors; those factors included, but were not limited to, a country’s carbon intensity (E), income equality (S), and control of corruption (G). It is certainly instructive to have a single score for each country but can that score tell us anything meaningful about the country—and importantly—generate investable information for investors?


Sources: Brandywine Global, Bloomberg and Macrobond. Please note: Spread (vertical axis) is measured in basis points (bps).This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


We’ve done this in Chart 1 above by taking our ESG score and determining if it “explains” a country’s interest rate spread relative to the 10-year U.S. Treasury note. The score produces the expected cross sectional results. The conclusion is simple: the higher a country’s ESG score, the more compressed its interest rate spread. The interest cost on the debt is lower for the higher-scoring countries. For low-scoring countries the signal is higher debt cost, and could serve as an early warning of a credit rating agency credit downgrade.

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.

Step Forward

The step forward needs to incorporate ESG directly into the research evaluation process. We took a page from the HSBCFixed Income Research Group, which created its own ESG model and more importantly, introduced an ESG factor into its Sovereign Credit Risk Score. We analyzed their model with the thought of making this research a part of our overall ESG efforts. Table 1 below depicts our utilization of the HSBC framework and reflects emerging market (EM) countries that are a part of our investment opportunity set.


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.


What should be obvious is that the macroeconomic, debt, and external variables are all the standard fare of country risk analysis, and are already an integral part of our research. The data are all the most currently available and forecasts are not used. We then simply ordered the data, giving a rank of 1 to 15, with 1 being the best and posing the least risk, 15 the worst. India, for example, has the fastest current economic growth rate, while Russia exhibits the largest current account surplus. So these two countries rank first in those categories, while Brazil has the largest budget deficit, giving it a rank of 15. The key: a lower rank suggests a lower risk.

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).


*Note: Factors included in our composite ESG score are Brandywine Global's Governance Score, Real GDP Growth, Inflation, Current Account Balance, Fiscal Balance, External Debt, Import Cover Ratio, and Credit Growth. Vertical axis, 5-Year Credit Default Swap (CDS) spread, is measured in basis points (bps).

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.


We report the best fitting model in Chart 2 above. That just happens to be the model that includes our more comprehensive governance score in the credit framework. This model produced the higher R-squared of the two. As a result, the HSBC-sourced credit scoring model with the addition of our comprehensive governance score appears to “fit” the 5-year country CDS reasonably well. This model may identify a pricing anomaly that could be potentially exploited. Of note are the countries that lay above the fitted line. Particularly, the Russia ruble and Brazilian real suggest an opportunity for CDS to fall; CDS and interest-rate spreads are highly correlated. The above model could be used to identify potential long or short positions, and investments where interest-rate compression could occur. That would be a return-generating investment for a sovereign bond investor. As always, further fundamental analysis is required to identify the investment catalyst.

One Step In Front Of the Other: Some Implications

By utilizing the HSBC framework we were able to incorporate governance into a credit scoring framework. However, this is not the end all and be all. The future steps to further develop the ESG framework of our analysis are partially listed below:

  1. 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.
  2. A variable weighting scheme needs to be developed. We would expect some variables to be more important than others.
  3. 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?
  4. 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.


1 HSBC Holdings plc is a British multinational banking and financial services holding company. It is the 7th largest bank in the world, and the largest in Europe, with total assets of US$2.558 trillion (as of December 2018). 


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.



IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

All Investors in EU and EEA countries ex UK and Switzerland:

Prior to 29 March 2019, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority. Subject to regulatory approval as of 29 March 2019, this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Number One, Ballsbridge, 126 Pembroke Road, Dublin 4. DO4 EP27.  Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Investors in Switzerland:

Issued and approved by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:

Issued and approved by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444


Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Discussions of individual securities are not intended and should not be relied upon as the basis to buy, sell or hold any security. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.