How index sovereign debt strategies can meet the challenges of an increasingly fragmented world

In March, the European Commission published the ReArm Europe Plan, intended to drive a surge of investment into the continent’s defence capabilities. The scale of the initiative, enabling spending of over €800 billion,[1] reflects the level of concern among European leaders about the long-term security of the continent.

For investors seeking environmental, social, and governance (ESG) integration in index government debt strategies, we believe the deterioration of the geopolitical landscape has profound implications.

It’s increasingly clear that security is a precondition for seeking to achieve national goals, including ESG goals, and that overlooking the impact of geopolitics may paint a distorted picture of the investment risks posed by national issuers of debt.

As such, we believe it may be appropriate in certain strategies to systematically assess geopolitical risk at the same level as ESG assessment.

A holistic approach to ESG scoring

Russia provides a pertinent example. Directly prior to invading Ukraine, some ESG assessments suggested the country had a relatively good ESG score.[2] This meant that investors driven by a desire to enhance the ESG profile of their sovereign investments were potentially blindsided by geopolitical risk.

This is why the LGIM Sovereign Risk ESG Framework,[3] in addition to the traditional E,S, and G pillars, incorporates a fourth pillar that captures geopolitical stability/risk. This framework is applied to some of our index funds across both emerging and developing market strategies, and can also be customised to suit the needs of individual clients.

Returning to the Russia example, the LGIM Sovereign Risk ESG Framework identified rising geopolitical risk and accordingly excluded the country’s debt from those portfolios using the framework before the invasion of Ukraine took place. The framework is able to achieve this in a purely systematic fashion, using third-party data and a transparent methodology[4] that eliminates any potential institutional bias.

By assessing topics including interstate tensions, trade sanctions, conflict intensity, exposure to regional conflict and civil unrest, this pillar aims to lower the risk of capital loss for investors by flagging potential risks to a sovereign’s ability to service its debt. We believe this is potentially valuable when assessing sovereigns as it adds a structural risk-mitigating element into the framework.

Overcoming wealth bias

Another critical factor that may distort ESG scoring of sovereigns is wealth. Developing countries generally have more limited means to improve their scores – their primary concern is different from developed countries, which have the funding to invest in sustainability.

As such, we see value in levelling the playing field between rich and poor countries when designing a methodology to assess countries’ ESG credentials. We think countries should not be overly penalised for certain areas of weakness. While metrics should capture weakness and score countries accordingly, overlap of metrics capturing the same factor should be avoided.

We think ‘wealth bands’ can help. This means peer grouping countries by their wealth levels, and tilting an end portfolio within the bands. This rewards the leaders and penalises the laggards within wealth bands, with countries in the highest wealth band held to a higher standard than those in lower bands.

How scores can be put to use

We use sovereign risk ESG scores in two ways: to set minimum standards in portfolios that use the framework and to tilt portfolios in certain index strategies.[5] We use the underlying data to score countries across a set of exclusionary factors. This allows us to identify countries falling short of our strategy-specific minimum standards. Standards for inclusion consist of globally recognised policies covering both sovereign-level standards and business principles that have a bearing on sovereigns, with the ultimate aim of mitigating financial risk.

The minimum standards thresholds are set specifically for each wealth band. Each wealth band remains mutually exclusive, and each wealth band has different standards for inclusion. This again holds wealthier countries to a higher standard.

Countries that meet the threshold for inclusion then become our investible universe in portfolios that use the framework. It is at this point that we use the final scores to tilt our portfolios. This means that countries scoring better will be rewarded with greater weighting in our sovereign debt index funds and vice versa.

Overcoming data lag

Score momentum is a key feature. By its nature, sovereign ESG data is refreshed more slowly than much corporate data, so to help mitigate this we apply a momentum factor which helps us forecast future risk by assessing the recent trend.

This can aid risk mitigation by potentially helping us get ahead of risky events.

The road ahead

We believe adoption of more dynamic sovereign ESG frameworks that capture geopolitical stability/risk alongside traditional ESG themes will become increasingly necessary in the context of an increasingly fragmented world.

In our view, the key to creating the next generation of frameworks is to have an approach to research and development that is alive to the practical realities of geopolitical risk, wealth bias and other challenges that characterise this space.  

As the world becomes more complex, it’s our view that advanced index capabilities will become increasingly necessary, providing investors with tools to help identify underlying sources of risk and return.

Whilst L&G has integrated Environmental, Social, and Governance (ESG) considerations into its investment decision-making and stewardship practices, this does not guarantee the achievement of responsible investing goals within funds that do not include specific ESG goals within their objectives.

 
[1] Source: https://ec.europa.eu/commission/presscorner/detail/en/ip_25_793
[2] Based on comparison of ESG scores with and without integration of our proprietary geopolitical risk pillar. Additionally, the J.P. Morgan JESG score for the country was also relatively good versus other investible EM countries immediately prior to the onset of hostilities.
[3] Powered by Verisk Maplecroft data.
[4] Methodology available here: LGIM Sovereign Risk ESG scoring framework overview
[5] This methodology applies to some of our sovereign debt index strategies, such as the L&G Future World Sovereign ESG Government Bond index funds.