ESG & government bonds

Raymond Verstraelen, Senior Portfolio Manager in Robeco’s Rates team, explains how the integration of ESG into its investment decision-making process is helping to navigate the eurozone debt crisis.

There’s a lot of hype at the moment around the integration of environmental, social and governance (ESG) factors into investment decision-making. Excitement around such fashionable topics often fades as rapidly as it develops. But as Raymond Verstraelen stresses, this is not just another fad. Nor is it a nice but non-essential add-on. At Robeco, it has become a central part of the investment framework.

On the fixed income side, the Rates team has been carrying out ESG analysis for four years now. Moreover, ESG has been fully integrated into the sovereign country-allocation process alongside two other, more-traditional inputs, the economic cycle and debt sustainability (see chart 1).

Chart 1: ESG is one of three key building blocks in country allocation model



Source: Robeco

It is given such a key role because it allows a deeper understanding of sovereign-debt dynamics that are not captured by these other types of research.

“Where traditional analysis stops, ESG continues,” explains Verstraelen. “ESG analysis gives more flavor about how a country is actually run. The power of ESG country analysis lies in its capability of identifying potential issues for countries in an early stage.”

ESG inputs need to be reliable and consistent
So how does this ESG research work on a day-to-day level? Key for the Rates team is to make their ESG analyses relevant to what is important for bond markets. Based on this requirement, their final ESG profiles are the result of a combination of discretionary in-house research and thorough analyses of the information from external ESG providers.

Verstraelen notes that this analysis is important to ensure that the external data is trustworthy, consistent and apposite. Meanwhile, the in-house research is necessary to capture important issues that are not properly covered by the team’s information providers.

One such issue is the aging of the population. To what extent does the government anticipate future age-related costs? What measures is it taking to ensure the sustainability of its finances?

Others include energy use—how does the country rank on energy use, dependency and efficiency, for instance—and political risk. “Data on issues such as social cohesion, government functioning and political risk help to identify potential risks and opportunities,” says Verstraelen.

The final step is including the final ESG profile in the investment decision-making process. As with most variables, the importance of ESG in forecasting future market moves varies. As a result, the weight given to ESG in any individual decision is not fixed. Rather, it is a judgment-call.

“Our ESG analysis gave us a significant head start in recognizing factors that would eventually contribute to France's downgrade”
Senior Portfolio Manager Raymond Verstraelen

Important guide in navigating eurozone debt crisis
Having looked at the nuts and bolts of ESG integration, let’s turn our attention to the impact the research has on investment decision-making.

Verstraelen points out that ESG analysis has been an important guide in navigating the treacherous waters of the eurozone crisis. “It enabled us to distinguish between countries more effectively in the early stages of the eurozone debt crisis. Political promises of growth and austerity could be looked at from a different angle, enabling us to better judge their feasibility,” he says.

ESG thus provided early danger signals that allowed the team to adjust its allocations to eurozone countries. “There is a direct connection between our analyses and our investment decisions,” says Verstraelen.

Greece & Portugal are worst ESG performers
So what did the ESG research reveal about the eurozone? As chart 2 shows, the rankings of the countries in EMU show that Finland and the Netherlands are the best performers on ESG. And at the other end of the scale are Greece, Portugal, Spain and Italy. It is no coincidence that these are generally the countries where the eurozone crisis has been most pronounced.

Chart 2: Robeco's ESG ranking of EMU countries 

 

Source: Robeco

Take Greece as an example. ESG analysis captured elements such as the weakness of Greece’s public institutions—there is no independent statistical office, for instance—the high level of corruption and the weak rule of law. “It is difficult to implement a turnaround when even such basic information as how many people live in a given area isn’t available,” observes Verstraelen.

ESG gave warning signals to reduce French holdings from 2010
But it isn’t just in identifying countries threatened with default that ESG analysis comes in handy. It is also useful in distinguishing between supposedly blue-chip countries given identical ratings by the ratings agencies.

Consider France. Until January, the country maintained a triple-A rating. But—well before the start of this year—the team’s analysis showed that France was significantly underperforming the Netherlands on ESG factors.

There were a number of issues responsible for that. First, French pension costs are high. Some pension reforms have been pushed through but they are not enough to deal with the problem comprehensively. Second, political stability is declining due to eroding popular support. Third, France's relatively inflexible labor market has weakened the country’s competitiveness. These issues mean that much-needed structural reform will be difficult to implement.

The warning lights were thus flashing. “Our ESG analysis gave us a significant head start in recognizing factors that would eventually contribute to France's downgrade,” says Verstraelen. “We started reducing holdings in France as early as 2010.” As an early adopter of an ESG approach at a country level, the team is now starting to reap the benefits.