In response to global client demand, AXA Investment Managers (AXA IM) has developed a new framework for analysing countries according to environmental, social and governance (ESG) criteria and reveals two ways investors may apply this to sovereign debt portfolios.
Matt Christensen, Global Head of Responsible Investment for AXA IM, comments: “We are seeing increasing interest from clients in ESG analysis that can be applied to asset classes such as sovereign debt. The eurozone crisis has only amplified this interest as the evaluation of sovereign issuers’ creditworthiness has been brought to the fore.”
A research paper by AXA IM’s Responsible Investment team, ‘Sovereign debt investing: ESG framework and applications’ outlines two ways that investors can draw upon ESG analysis for their sovereign debt portfolios. The first addresses investors’ desire to limit reputational risk by screening the investment universe using specific ESG criteria before the portfolio construction phase.
One of AXA IM’s clients asked the firm to minimise the reputational risk of their existing emerging markets sovereign portfolio holdings. The rules-based reputational screen identified 10 (from a total of 57) sovereign issuers that presented significant reputational risk – representing 9.7% of the universe’s market capitalisation.
The move to rules-based screening did not significantly alter the quality, yield and duration characteristics of the portfolio. In terms of credit quality, the risk screen reduced the percentage of highly speculative debts and this quality improvement was without significant impact to the yield and duration.
“A key issue for investors is the long-term sustainability of a country’s economic and political situation and therefore addressing ESG issues naturally aligns with this. In addition, many institutional investors wish to limit reputational or headline risk in order to avoid negative perceptions associated with a particular activity or regime. Investors may find a reputational risk strategy based on negative screening particularly useful for emerging markets since these countries tend to score poorly on governance measures such as control of corruption relative to developed markets” explains Matt Christensen.
The research also examined how an ESG overlay would impact a sovereign debt portfolio’s key characteristics. The study showed that an ESG overlay within defined risk parameters does affect country allocation and can improve the ESG performance of a sovereign debt portfolio whilst having a limited impact on other key portfolio characteristics including quality and duration.
The top ESG over-weights for emerging markets were Poland and Chile. For developed markets, Spain topped the list for its better than average ESG score, despite a poor S&P long-term rating and gloomy economic prospects. The top ESG under-weights for emerging markets were the Philippines, Columbia and Indonesia. For developed markets, Japan was the largest underweight largely due to governance issues, while sovereigns with high quality long-term ratings such as the United Kingdom and the United States were slightly underweight largely as a result of poor environmental indicators.
Craig Hurt, Sydney-based Director of AXA Investment Managers in Australia and New Zealand, said ESG factors may be becoming more material to sovereign debt investing and investors are taking note.
“We’ve begun to examine the different ways in which ESG criteria can be applied to sovereign debt portfolios. We are already using this ESG country framework in our core RI funds, but see an opportunity to expand this into our mainstream funds. The strength of our model is its flexibility, which allows us to propose different ways to integrate ESG criteria according to a fund’s specific objectives and the client’s requirements.
“Through the ongoing expansion of our global RI research and initiatives, we aim to offer Australian institutional investors – and their individual members and investors – a wider opportunity to invest in strategies incorporating ESG principles,” Mr Hurt concluded.
