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The new ESG risks for sovereign bonds

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Hello from New York. For all the environmental, social and governance (ESG) obituary writers out there, pens down: There is good news for ESG in the bond market.

From the beginning of the year to the end of April, ESG funds saw $7.4bn in inflows while non-ESG funds reported $168bn in outflows, according to a report from Bank of America on June 8. (The BofA analysts literally wrote “wow!” after reporting their findings).

In the US specifically, ESG bond funds saw $2.9bn for the period compared with $80bn in cash out of the door for the rest of the bond fund universe.

The strong demand for fixed-income ESG bond funds contrasts with shakier performance in their equities-focused counterparts, which have been hit by factors including rising energy prices.

But there are some more worrying signals amid those strong flows. As Simon highlights in today’s edition, bond investors may be underestimating serious ESG risks around their sovereign debt portfolios. And I have a report on the controversial issue of ESG short selling. Thank you for reading. (Patrick Temple-West)

Russia’s war: the tough ESG lessons for bond investors

Investors in Russian sovereign debt are sitting on hefty losses after Vladimir Putin’s invasion of Ukraine sent the value of his country’s bonds into freefall. Could they have avoided that outcome by paying more attention to environmental, social and governance factors? And could they protect themselves against similar losses by waking up to ESG risks in other troubled nations?

That’s the argument of analysts at Verisk Maplecroft, who have published new research showing that 15 hard-currency sovereign debt issuers have even worse ESG risks than Russia.

The situation facing Russian bond investors is an example — albeit an extreme one — of the perils facing investors who take a complacent approach to sovereign ESG risks, David Wille, financial sector risk analyst at Verisk, told Moral Money. Well before the invasion, Verisk’s ESG metrics for Russia gave “a sense that something is wrong here”, Wille said, with Russia receiving a score similar to “Venezuela or Iran, which are already pariahs — whereas its debt was being priced similar to countries like Lithuania”.

So which other countries’ ESG performance should investors be worried about, according to Verisk?

President Recep Tayyip Erdoğan of Turkey
President Recep Tayyip Erdoğan of Turkey. The country scored worse than Russia in Verisk’s rating system © AP

One important case is Turkey, a big bond issuer that ranks two notches below Russia on Verisk’s 15-point scale, reflecting President Recep Tayyip Erdoğan’s continuing crackdown on civil freedoms and the separation of powers. Egypt, Peru and Nigeria are among the other nations coming in behind Russia. China and Saudi Arabia, while ahead of Russia, also score poorly.

These results might raise eyebrows among those who note that Peru, for all its recent political unrest, has not invaded a South American neighbour. But rather than giving a verdict on a country’s ethical credentials, Verisk’s recently launched rating system is intended to give greater clarity on material risks that have received too little investor attention, said Wille.

Turkey scored even worse than Russia because of its dire performance on issues such as labour rights and food security, he said. And Russia’s environmental score — despite the climate impact of its giant oil and gas industry — benefited from slight “improvements in its regulatory framework”.

Verisk’s in-house analysis shows a clear relationship between its ESG ratings and sovereign debt performance, with the former often serving as a lead indicator for the latter, according to Wille. That chimes with other research showing the potential utility of such data to investors, even leaving aside moral considerations. JPMorgan found that the ESG versions of its emerging market debt indices offered similar returns but with lower volatility. Pimco analysts showed that high ESG performance came with lower credit spreads for sovereign issuers, “over and above the effect of any macroeconomic and financial variables”.

Verisk, and other providers of national-level ESG data, will now hope to capitalise on a surge in attention to country risk, as investors look to get ahead of the next crisis. “When something happens, like a coup or war, the markets react straight away,” said Eileen Gavin, global markets analyst at Verisk. “But there are lots of softer things happening — interference with electoral processes, subtle changes in laws — that are not being picked up.” (Simon Mundy)

Short selling ‘essential’ to ESG goals, hedge funds argue

The Man Group logo at offices in London
Man Group argued that shorting could not serve as a carbon offset © REUTERS

It is one of the more controversial topics in ESG: does short selling deserve to play a role in socially conscious investing? Former Japanese pension chief Hiro Mizuno kicked off the debate when he stopped lending to short sellers in 2019, arguing they do a disservice to long-term investing.

Then earlier this year, Man Group, one of the world’s largest hedge funds, stirred the pot by arguing that shorting cannot serve as a carbon offset. Shorting, in lieu of actually cutting emissions, “will come across as inauthentic and likely not endear hedge funds to the climate cause”, Man’s co-head of responsible investment Jason Mitchell wrote in the FT.

(In essence, short sellers borrow shares to sell and then buy them back at a lower price, making money on the difference.)

Man’s position uncorked a round of pushback (see here and here). And now the hedge fund’s main lobbying group in Washington has weighed in to argue that short selling is ESG friendly. In a new report published today, the Managed Funds Association reported that “short selling can potentially reallocate $50bn-$140bn of investments away from the most heavily polluting companies.”

The paper argues that short selling “can be an essential tool to accomplish ESG goals by helping reallocate capital away from high-emissions companies all while maintaining investment performance”.

Shorting can be used as a hedging tool against climate risks and it can tilt investments toward carbon neutral positions, the Managed Funds Association said.

But why all the fuss now about the ESG qualifications for short selling?

Hedge funds are jostling to win business from pension funds and sovereign wealth funds that have been putting growing weight on sustainability issues. So they have an incentive to play down concerns that short selling — a central tool for many hedge funds — could undermine ESG goals. What’s certain is that this report is unlikely to be the last in the debate. (Patrick Temple-West)

Smart read

  • About a year ago, Canada’s big oil sands in the country’s midwest were shunned by oil majors and ESG investors alike. But now, the mood is brightening in Alberta, writes our Energy Source colleague Derek Brower. “Production is rising again. So is export capacity: a pipeline system to the midwest has been expanded and another to the west coast is due online next year. Across the province’s oil patch, business is suddenly brisk.”

Sustainable Views

If you’ve been enjoying Moral Money, you might want to check out Sustainable Views — a new service for sustainable finance professionals from the FT’s specialist arm, providing deep dives into ESG policy and regulation every Tuesday and Thursday. It’s a great resource to help you stay on top of developments in this fast-moving space. The latest edition looked at a new European directive on gender targets for corporate boards, and the use of ESG factors in securities lending. You can sign up for a free trial here.

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