For government bond portfolios, we have resources available to help investors assess the ESG risks or opportunities that would impact the long-term economic growth and sustainable development of the respective countries. For example, ESG issues relative to sovereign bonds can include political stability, corruption, social inequality, investment in education, and climate change management.
In addition, portfolio managers may develop their own custom approach to ESG integration. For example, we employ a proprietary country scoring model in our Emerging Markets Debt approach that enables us to quantify the sovereign credit outlook for the 60 emerging market countries that we cover and rank them according to their credit strength from high to low. The primary aim of the model is to provide greater rigor to our country research and to highlight potential vulnerabilities in individual countries. The resulting score for each country is adjusted to reflect important qualitative factors such as political stability, which then facilitates cross-country comparisons. The country scoring model is one element of the research process, and as such the Portfolio Manager does not have to override the output of the model.
The scoring process begins with a top-down quantitative assessment of macroeconomic and debt sustainability conditions using a proprietary model that assigns a numerical score to each emerging markets country. The specific inputs and their weights in the model are proprietary, but they include what we have determined to be the key drivers of credit spreads, such as a country's economic performance and debt burden, the government's fiscal position, and the country's quality of governance. Overall, the model employs 10 factors that we found to be the most valuable in determining the credit strength of individual countries.
In emerging markets, however, quantitative measures alone cannot tell the whole story. Rather, the quantitative component of the analysis ensures that every country is reviewed with the same disciplined framework. Our team of experienced sovereign analysts then adapts the raw quantitative score to reflect those less quantifiable factors that may have a meaningful impact on credit spreads, such as political risk, central bank independence, and structural reform progress. Usually, the quantitative and fundamental credit scores are similar, however, in some cases; the politics are such that the final score is meaningfully different than the raw credit score, reflecting a greater credit risk than the numbers alone might imply.
The core of the country scoring model has remained consistent since the inception of our emerging markets debt approach in 1999. We do recalibrate the model every few years, however, in order to refine the specific factors and improve the effectiveness of the model.
Historically, research has focused on a sovereign’s ability to pay its debts. However, ability to pay is no longer the only consideration for investors; they also need to gauge the willingness of sovereigns to make their bond payments. We use a number of factors to gauge the ability and willingness of governments to pay their debts. Inputs include contingent liabilities of the state or metrics such as total debt to exports or revenue to debt, among others. However, the issue of willingness to pay necessitates the inclusion of politics into one’s risk assessments, as it can be a major factor in determining how bond markets will behave.
To assess willingness to pay, we consider the World Bank’s Government Effectiveness index in our bond rating analysis. Research shows that sovereigns with strong governance scores tend to be awarded high credit ratings, while countries regarded as having corruption problems tend to have lower credit ratings.
Inputs that can be used to assess the ability to pay include financial and economic ratios as the ones mentioned above. However, to assess the ability to pay, we also look at social factors, such as the World Bank’s Ease of Doing Business index, which indicates how well the regulatory framework in a country supports the setting up and running of businesses. The more-business friendly a country is, the higher tends to be the credit rating. A business-friendly environment is also consistent with higher tax revenues for the state that positively affect the ability to pay.