Sovereign bonds and ESG: A bridge too far?

Perhaps it is a fool's errand to try and reconcile market beta and the subjective process of ranking countries' moral credentials

Jamie Gordon

a wooden bridge over a river

Environmental, social and governance (ESG) investing has gone from a bleeding-heart periphery movement to becoming a dominant force in core equity and corporate debt allocations – but is mixing ESG and government bonds a step too far?

Equity products certainly led the charge on ESG but the post-pandemic push to ‘build back better’ and the introduction of phase one of the Sustainable Finance Disclosure Regulation (SFDR) earlier this year have both sharpened investors’ focus on greening their fixed income exposures.

During the first four months of 2021, virtually all net flows into bond ETFs went into ESG products. During the year to the end of August, ESG fixed income ETFs amassed €13.4bn new assets, still ahead of the €12.2bn gathered by their non-ESG equivalents, according to data from Bloomberg Intelligence.

Owing to what has already been a breakthrough year for ESG investing, there has been an increasing number of eyes on the product class and a growing number of red flags raised, including some unsavoury exposures spotted in ETFs with supposedly virtuous methodologies, IOSCO highlighting a lack of standardisation in ESG ratings and data collection, and InfluenceMap finding 71% of ESG funds currently fall short of Paris Agreement goals.

There are also concerns particular to fixed income and ESG, such as doubts around the possibility of engagement. Whereas owning equity in a company allows shareholders to exert some influence – most often through voting processes – opportunities for engagement between bond issuers and owners are less apparent.

Fixed income proponents argue passively owning a bond ETF over time allows dialogue to build up between the two parties in the longer-term, offering another avenue for engagement. However, while pleasant in theory, such ideas seem less convincing in the context of ESG funds exerting influence on political and monetary policymakers.

Vincent Deluard, global macro strategist at StoneX, said engagement is particularly ineffective where the governments and central banks of developed and larger nations are concerned, and these are also the mainstay of passive fixed income products.

“The UK, Japan, or the US will always find buyers for their government bonds, if only because their central banks can monetize their debt”, Deluard said.

“The whole idea is to tilt holdings to achieve non-financial goals, but at the same time index providers cannot deviate from the benchmark too much. So, while ESG equity ETFs own the same big five US tech stocks, ESG bond ETFs end up buying US Treasuries and Japanese Government Bonds because these are the biggest, most liquid bond markets.”

Another issue is the fact ranking sovereign issuers on ESG performance is doomed to subjectivity. Unlike corporate debt, the investment universes for sovereign debt exposures are comparatively small. Not only does this mean indexers are less likely to perform exclusions in the interest of preserving diversification and performance versus non-ESG benchmarks, but also, in actors as multifaceted as nation-states, ESG non-adherence will be found one way or another in every potential constituent.

Issuers’ task of deciding which is the lesser of evils, and ensuring the optimal risk-return profile, will inevitably provoke backlash on what are emotionally sensitive judgements. If such a process is possible or appropriate, using a set of scoring metrics is unlikely to produce a broadly agreeable result, let alone one with sufficient nuance.

Detlef Glow, head of Lipper EMEA Research at Refinitv, noted: “There are so many criteria which can impact the ESG performance of a country or state (climate and environmental protection policies, export of weapons, fair taxation schemes, human rights, labour laws and so on) that it may become quite hard to build a portfolio that can be considered ESG compliant by all means, as even countries or states which are considered to have a “good ESG performance” may have some weaknesses with one or the other criteria.

“From my point of view it is very hard to combine ESG and sovereign debt, as the interests of a state (even as they may want to do good) with regard to the well-being of its inhabitants and the overall economy are somewhat different than the interest of corporations to maximize revenues and shareholder value.”

ESG sovereign bond ETFs – a mostly underwhelming roster

Despite the obvious challenges and sceptical onlookers in the industry, some issuers have given ESG government bond ETFs their best shot. One example is the UBS ETF J.P. Morgan Global Government ESG Liquid Bond UCITS ETF (EGOV), which is currently the only UCITS ETF labelled as “ESG” while offering a global sovereign debt exposure.

Taking its parent index of liquid sovereign bonds, the J.P. Morgan Global Government ESG Liquid Bond index underlying EGOV then categorises all countries into ten bands based on ESG performance, with the lowest five being excluded from the index.

Unfortunately, the resulting basket looks very similar to vanilla equivalents. In fact, EGOV ends up having the same top nine country weightings as the non-ESG Amundi Index J.P. Morgan GBI Global Govies UCITS ETF (GOVU), with both featuring weightings of over 40% apiece to US Treasuries. Not only is this a run-of-the-mill exposure in non-ESG products, but also one that means EGOV’s largest weighting is towards a country with the highest military expenditure in the world, large fracking and offshore fossil fuel extraction operations, overseas military involvement and one where the death penalty is legal in many regions.

Not mixing his words, Deluard said: “This seems like using the ESG label as a marketing gimmick to attract money to a very ordinary bond fund.”

Unfortunately, a similar, small group of issuers tend to appear in most market-cap weighted indices containing government bonds from developed market issuers. Speaking candidly at ETF Stream’s ETF Ecosystem Unwrapped event earlier in the year, Mathieu Guignard, Amundi’s global head of product development and capital markets, said developed market sovereign debt is a small universe and removing one or more constituents can introduce bias and notable changes to an ETF’s risk profile.

“For developed market government bonds, we reweight the portfolio by overweighting or underweighting each country according to ESG criteria,” Guignard said. “But this is a fairly light approach compared to what we do in equity and corporate bond portfolios, where you can exclude up to 75 or 80% of the original universe.”

Alan Miller, CIO at SCM Direct, said on the process of ranking developed market issuers on ESG performance: “It may be useful in the future should the quality of data and ratings improve but until then the exercise is simply not worth pursuing.”

Deluard added: “The concept of “sovereign ESG” for large developed countries is nonsensical. The idea behind ESG is that investors will force positive change by depriving bad actors from capital, and rewarding virtuous ones with cheap funding.

“This may work if ESG-driven investors represent a critical mass – maybe for a small mining company for example. But I already struggle to see this work for Apple or Walmart.”

Thankfully, there are potential avenues for avoiding large concentrations in very ordinary developed market sovereign debt, including fixed income ESG ETFs focused on emerging markets (EM), single country exposures, climate-specific methodologies and perhaps most promising, green bonds.

On EM, ESG investors might look to the L&G ESG Emerging Markets Government Bond (USD) 0-5 Year UCITS ETF (EMD5). This product from Legal and General Investment Management has 153 holdings, with only three of its top nine weightings overlapping with those of Europe’s most popular non-ESG EM government debt product, the SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (SYBM).

On a less positive note, EMD5 is one of the two ESG fixed income ETFs with the greatest exposure to what Freedom House defines as countries that are ‘not free’. Such exposures include the UAE, Oman, Saudi Arabia and Qatar, all of which have a reputation for poor human rights, while the governments of other weightings – Poland, Brazil and the Philippines – have actively regressed their countries’ civil liberties in recent years.

Unfortunately, the other ETF flagged by Freedom House’s definitions is also from LGIM, the L&G ESG China CNY Bond UCITS ETF (DRGN). This ETF has received a lot of publicity due to its 100% exposure to Sino government bonds, with many ETF industry participants, including SCM Direct’s Miller, being outspoken against it.

“This is patent nonsense and is a classic example of garbage in, garbage out,” Miller told ETF Insider. “Such bogus methodologies shame not just the issuers but the entire investment industry and the FCA for allowing such practises.”

Deluard agreed, saying: “I see 62% of the fund goes to China Government Bonds and another 38% to its biggest banks, which are effectively state-controlled.

“If you want to be provocative about it […] this ESG ETF eventually finances the genocide of the Uyghurs and aggressive military spending with the end goal of taking over Taiwan.”

For those not looking to depart from developed market sovereign debt entirely, climate ETFs such as the iShares € Govt Bond Climate UCITS ETF (SECD) offer some tangible differentiation from their parent indices. Tracking the FTSE Advanced Climate Risk-Adjusted European Monetary Union Government Bond index, SECD is 8.7% overweight France and 6.4% underweight Spanish government bonds, allowing it to be 2% less carbon-intensive than products tracking FTSE’s vanilla EMU Government Bond index.

Regrettably, SECD’s underlying index still falls 2.4% short of the 2050 two-degree Celsius greenhouse gas emissions target – half a percent better than its non-ESG equivalent. The two indices’ returns are also extremely correlated, with less than a 20% performance gap after two decades of back testing. Further, the non-ESG benchmark was actually closer to achieving the 2050 emissions target for two extended periods between 2003 and 2011.

The final and perhaps most hopeful route for achieving sustainable sovereign bond exposure within a wrapped product is green bond ETFs.  A strong example is the Lyxor Euro Government Green Bond UCITS ETF (ERTH), which launched in July as one of a small number of government fixed income products classified as Article 9 under the SFDR.

Tracking the Solactive Euro Government Green Bond index, ERTH gives investors direct exposure to European government’s efforts to raise capital for climate mitigation or adaptation projects. As of July 2021, European governments had issued 90% of the world’s sovereign green bonds.

Accepting the limitations of ESG in sovereign debt

While looking to funds such as ERTH and SECD, investors should be wary of conflating ESG and climate issues. While there is some overlap, incorporating ‘E’, ‘S’ and ‘G’ considerations simultaneously is a more complex task – and even more so when ranking the sum of countries’ political and monetary policies.

Sympathetic to this challenge, Glow said market cap-weighted indices make sense as they allocate to the most liquid securities, which is an important consideration in products such as ETFs and mutual funds, especially because institutional investors benchmark their portfolios against the vanilla indices of large index promoters.

In turn, he adds there is a trade-off between the “better” ESG performance called for by the media and market observers, and the “lighter green” approach favoured by participants not wanting to stray too far from market beta.

“From my point of view it is ok when an index promoter is using a best-in-class approach, as long as this is clearly described in the respective index methodology and communicated to investors.

He continued:This topic is really philosophical as the world is not as perfect and easy to determine from an ESG point of view as one may wish. With regard to this, I think that transparency on methodologies and valuation matrixes used is in general key for all [ESG] indices and investment products, as this enables investors to make educated decisions if the respective methodology to determine and weight the constituents within an [ESG] index fits their personal needs or not.”

Having little patience for greenwashing, Miller concluded: “The problem is that such ratings and systems are incredibly subjective and totally suspect and it would be better to stop paying lip service to ESG and just admit that at present we cannot select investments in government entities and pretend they meet the same standards we set for corporate entities.”

Instead, he says issuers should opt for one of three paths. One, they could apply the same principles to investing in government bonds as they do for corporate debt, with the end result likely being they exclude government investments from ESG products altogether. Two, they should encourage an organisation such as the United Nations to produce a ‘red list’ and these countries will be de facto excluded from all ESG fixed income ETFs. Three, they could tilt to countries with better overall ESG scores but admit there is little consensus on these scores between data providers or end investors – and in turn this may make little difference or sense in practice.

This article first appeared in ETF Insider, ETF Stream's new monthly ETF magazine for professional investors in Europe. To access the full issue,click here.