How to Avoid the Next Sovereign Debt Crisis

Applying environmental, social, and governance (ESG) criteria to government bonds can help investors steer clear of the most indebted nations, according to Standard & Poor’s Dow Jones Indices (S&P DJI).

“Incorporating ESG country risk metrics can help to better understand and potentially reduce risk in sovereign bond portfolios.”In a report co-written by staff from S&P DJI and fund manager Robeco, the authors used more than 250 data points to establish 17 “indicators” for rating government bonds.

“Incorporating ESG country risk metrics can help to better understand and potentially reduce risk in sovereign bond portfolios,” the authors wrote.

Sustainability “is an important element of a country’s long-term risk profile,” they added. Among the criteria examined by Robeco to establish the ESG “scores” were a country’s reliance on energy imports, renewable energy generation, economic competitiveness, political risk, life expectancy, and per capita income.

Traditional fixed-income indices that weight exposure by the volume of market issuance can “indirectly imply higher risk,” the report said.

“During the European debt crisis of 2009, the investors in these indices were overexposed to highly indebted countries, such as Greece or Italy, which led to a higher volatility of returns,” the authors wrote.

Greece’s weighting in S&P DJI’s Pan-Europe Developed Sovereign Bond index declined gradually from just under 5% in May 2008 to zero four years later as it grappled with crippling debt repayments. In the index provider’s recently launched ESG version of the same benchmark, Greece would have remained less than 1% of the index over that period.

The ESG-weighted index also maintains a substantially lower exposure to Italy, a country with the world’s third-highest debt-to-GDP ratio at 132%. UK government bonds make up roughly 30% of the ESG index currently, compared with around 20% of the traditional benchmark.

The full report, “Integrating ESG into Sovereign Bond Portfolios,” can be accessed on S&P DJI’s website.