Country sustainability analysis: a crucial yard-stick for investors
Used in combination with traditional sovereign bond ratings, country sustainability rankings can be a powerful tool to enhance risk analysis for government bonds, enabling investors to make better-informed investment decisions. When countries fail to adequately and proactively address challenges that they face in social, environmental and governance areas, such challenges can eventually manifest themselves in disruptive economic or financial incidents. That’s one of the reasons why in 2002 KBC started to conduct internal research into the sustainability profile of countries on behalf of its SRI funds.
Investments in government securities generally rely on the judgement of credit rating agencies. These are independent private companies that assess the creditworthiness of debt issuers and the quality of the debt instruments themselves. Using risk models, they assess the likelihood that these issuers will not be able to repay their short and long-term debts. For professional investors, such as banks, insurers and pension funds, the ratings are a measure of the financial health of governments and an important addition to their own risk models. The level of the rating serves as a guideline for the risk premium that must be included in the return on debt securities.
Traditionally, credit agencies produce their ratings only to identify purely economic and financial risks, such as the issuer’s solvency and liquidity. For countries, this is usually done on the basis of variables that assess their macroeconomic and financial stability. The most important ones are a country’s long-term economic growth potential, balance of payments dynamics and competitiveness, external debt, public debt, and political stability.
Credit agencies’ reputations were seriously damaged during the 2008 financial crisis, as they awarded high grades to debts that later turned out to be high-risk investments. Though they are still an important aspect of risk analysis, investors now understand the limitations of credit rating agencies, and therefore welcome additional ways to assess government debt riskiness. The far-reaching consequences of events such as the 2008 financial crisis and the subsequent European sovereign debt crisis have led to a growing recognition that the assessment of countries for sustainability issues in the social, environmental and governance areas is a useful complement to traditional economic and financial analysis. It gave impetus to Socially Responsible Investing (SRI) in government bonds in the recent decade. In 2017, they accounted for some 15% of total sustainable investment capital in Europe (Eurosif, 2018).
Relevance of sustainability issues
A country that invests in the sustainable promotion of the general welfare of its citizens lays the basis for a favourable and stable economic and political development in the future. Such investment promotes the accumulation and quality of the production factors labour and capital. Examples include good governance and well-functioning institutions (legislation and regulations, education, health care, justice, etc.). These create the framework within which it pays for individuals to go to school and work longer, and for companies to invest and create jobs. Countries that score well in terms of sustainability usually also have a rich ‘social capital’ (i.e. the presence of trust in citizens, the existence of networks, flourishing institutions, etc.) and less chance of financial and economic hardship. Post-financial crisis, there is sense that society in general wants more transparency when it comes to financial markets and investing. Providing a framework for analysing sustainable practices adds information and transparency to the investment process. Furthermore, since SRI carries an element of moral judgement, the definition of what is socially responsible can change from person to person and over time. A clear framework for ranking countries gives structure to the concept of sustainable investing, helping investors analyse risk.
From a theoretical perspective, there is also a disadvantage of including sustainability issues in the decision process to invest in government bonds, however. Asset managers take into account not only the expected return but also the risk in the composition of their portfolios. That is why they aim for a broad diversification of their investments. However, sustainability criteria impose additional, non-financial restrictions on their investment decisions. This limits their diversification possibilities and increases, all other things being equal, the risk of investment portfolios.
The relative performance of conventional versus sustainable investments in terms of return and risk is ultimately an empirical question. Studies clearly show that SRI products do not in practice perform manifestly worse or better than traditional investments, when taking both return and risk into account. This also applies to investments in sustainable bonds. But there is more: anyone who invests sustainably usually does so on the basis of the fundamental choice to strive for social added value in addition to the hoped-for financial return. Apart from the performance of the investment, the added value of the sustainability analysis of countries therefore also consists of the extra, non-financial dimension offered to investors.
KBC’s country sustainability barometer
KBC has a long-standing expertise in analyzing the sustainability profiles of countries. It first began to conduct internal research into country level sustainability as early as 2002. KBC’s country sustainability framework evaluates 42 developed countries and 77 emerging countries on a broad range of economic, social, environmental and governance factors. It consists of five main themes, each of which is based on various sub-indicators: (1) General economic performance and stability; (2) Socio-economic development of population; (3) Equality, freedom and rights of population; (4) Environmental performance and commitment; and (5) Security, peace and international relations. The country rankings (the so-called ‘KBC Developed Markets Sustainability Barometer’ and ‘KBC Emerging Markets Sustainability Barometer’) are updated annually. A universe of sustainable countries in which the KBC SRI funds can invest is determined according to the ‘best in class’ principle.
A detailed description of the screening methodology and the 2018 update of the two sustainability barometers can be found in two research reports that we publish in combination with this opinion (see Barometer Developed Countries and Barometer Emerging Countries). Switzerland and the Scandinavian countries take the leading positions in the ranking of developed countries. Belgium takes the 13th position in the group of 42 developed countries considered. Relative to its neighbouring countries, Belgium scores below Germany and the Netherlands (7th and 8th place, respectively) and close to France (12th place). Among the emerging countries, Singapore, Slovenia and Lithuania top the ranking. More generally, the Central and Eastern European countries score quite well in the barometer. In total, 21 developed countries and 17 emerging countries are eligible for investment in KBC’s SRI funds.
1/ The link between sustainability aspects on the one hand and economic development and political stability on the other has been amply demonstrated in the literature. See for example Mellios & Paget-Blanc (2006) and North et al. (2008).
2/ For a literature review on the financial performance of SRI funds, see KBC Economic Bulletin No. 20 (2014). For studies on the performance of sustainable bonds, see Derwall & Koedijk (2009), Drut (2010) and Leite & Cortez (2016).