Sovereign Bonds: The ESG Factor

Mid Week Bond Update

Sovereign Bonds: The ESG Factor

A timely look at how ESG principles might factor into sovereign debt analysis; bond investors got some upside news on the U.S. economy; China's latest goals could benefit debtholders.

Sovereign Bonds: The ESG Factor

Investment managers have become increasingly engaged with how environmental, social and governance (ESG) factors can be used to enhance fundamental research.  While ESG is often associated with equity analysis, recent work by Brandywine Global offers intriguing insight into what these factors may reveal with respect to sovereign bond analysis.

The analysis begins with an ESG ratings framework which combines scores reflecting macroeconomic and credit quality conditions as well as the quality of a country's overall governance – generating an overall ESG rating.

One key finding: the better a country does on Brandywine Global's ESG score, the better its sovereign bonds have done in terms of spread to U.S. Treasuries over a 12-month period.

ESG Scores vs. Sovereign Spreads

Chart courtesy of Brandywine Global. Sources: Brandywine Global, Bloomberg and Macrobond, as of 1/31/2019. 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.

*Note: Factors included in the 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.


While the relationship is clear, it isn’t strong from a statistical point of view, with a relatively low R2 of about 0.35. The important issue going forward is how to refine the way governance is rated and incorporated into a credit-scoring framework, including the identification of additional factors, the appropriate weightings, and potentially increasing the coverage of specific countries as market needs evolve.

On the rise: U.S. economic fundamentals

Fixed-income investors worried about what a recession could do to returns had some positive news from the U.S. housing market, with new home sales rising unexpectedly in December, reflecting the dual impacts of lower mortgage rates and more-affordable properties. December sales increased to a 621,000 unit annualized pace from a downwardly-revised November figure. The median sale price was down 7.2% from the previous year’s December.

There was also good news in terms of consumer confidence, as expressed in the willingness to buy on credit. Total credit-card debt hit $870 bn, the largest amount on record, as of December 2018, up by $26 bn from Q3. The December 2018 figure topped the previous record of $866 bn, reached at the end of 2008. While some of the credit card debt in December may have been prompted by strains in government employees' household finances due to the start of the partial government shutdown toward the end of December, overall willingness to finance consumption on credit cards appears steady so far.

As of the end of 2018, credit cards were the fourth-largest portion of consumer debt, after mortgages, student loans and auto debt. The total debt for all four categories added up to $13.5 trillion, a new record.

On the slide: China’s growth target – and taxes

Investors in China's bond markets received some good news in terms of credit quality during the week, as Premier Li Keqiang opened this year’s National People’s Congress on a cautious note, saying that the country faced a “tough economic battle ahead”. Mr. Li presented a new official target for overall economic growth – a range of 6% to 6.5% for 2019, down from the 2018 target of “about” 6.5%.  The new target was announced at the beginning of the sessions, along with a package of tax cuts adding up to nearly 2 trillion yuan ($298 billion), including a $90 billion cut in the top tier of the value added tax rate (VAT) for factories. In addition, the target for the country’s budget deficit was said to be widened to 2.8% of GDP from 2.6%.

Observers noted that the plan called upon more use of reduced taxes as economic stimulus than in previous years, which had been characterized by deficit spending on countrywide mega-projects. And to the extent that owners of Chinese corporate bonds have been worried about erosion of credit quality as indebtedness increased, the reduced pressure on corporate cash flow due to tax cuts could be seen as a net positive.


All data Source: Bloomberg as of March 6, 2019 unless otherwise specified.

R-squared, or R2 is a statistical measure of how close data series are to a fitted regression line. The definition of R-squared is fairly straight-forward; it is the percentage of the response variable variation that is explained by a linear model.



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