Two Essays on ESG Investing in Sovereign Bond Markets
Impact of ESG Criteria on the Risk and Return of Sovereign Bonds: We provide an assessment of the materiality and impact of ESG scores taken individually on key risk and return indicators of relevance to asset owners in both developed and emerging markets. Our main goal is to analyze whether cross-sectional differences in the risk and return of sovereign bonds from various developed and emerging issuing countries can be explained partly by cross-sectional differences in E, S or G scores. We draw an important distinction between the perspective of long-term buy-and-hold investors, for whom performance can be captured by bond yield spreads, and the perspective of shorter-term investors, who will not hold the bond until maturity, and as such cannot use bond yield as a measure of expected performance because of the uncertainty regarding the selling price of the sovereign bonds held in their portfolios. In the latter case, we instead use average annualized return as a measure of performance. We find that higher environmental scores for developed countries and higher social scores for emerging countries are associated with lower costs of borrowing for issuers and consequently with lower yields for investors. We also find that higher environmental and governance scores for developed countries and higher social scores for emerging countries are associated with lower bond return.
ESG Integration in Sovereign Bond Portfolios: The integration of ESG constraints into investment decisions can be assumed to involve an opportunity cost with respect to the outcome that would be optimally achieved in the absence of ESG considerations. This opportunity cost can be measured in terms of a possible increase in the risk and reduction in performance and/or in terms of an increase in tracking error with respect to the benchmark. The main contribution of this paper is to demonstrate that implementation choices regarding how ESG constraints are incorporated in the context of sovereign bond portfolio construction have a material impact on this opportunity cost. Finally, we also explore the benefits of ESG momentum strategies, defined as strategies designed to exploit time-series differences in ESG scores, as opposed to exploiting cross-sectional differences in these scores. In particular, we confirm that negative screening leads to more diversified portfolios and lower levels of tracking error, while positive screening leads to higher levels of improvement of ESG scores, at the cost of an increase in absolute and relative risk budgets. In an attempt to alleviate some of these concerns, we find that a dedicated focus on absolute or relative risk reduction at the selection stage allows investors to reduce the opportunity costs along the dimension that is most important to them. Finally, we provide evidence that ESG momentum strategies in sovereign bond markets can be used to further reduce some of the aforementioned opportunity costs. Overall, our results suggest that sound risk management practices are critically important in allowing investors to incorporate ESG constraints in investment decisions at an acceptable cost in terms of dollar or risk budgets.
Supervisor: Lionel Martellini, EDHEC Business School
External reviewer: Eric Jondeau, University of Lausanne, Swiss Finance Institute
Other committee member: Enrique Schroth, EDHEC Business School