Time for Sovereign Investors to Get on Board

Kamesh Korangi, Head of Portfolio Strategy, and Jo Richardson, Head of Research at the Anthropocene Fixed Income Institute, analyse the impact of climate risks on sovereign bond yields.

Sovereign bonds are the unsung drivers of climate transition. Governments are increasingly relying on these instruments to raise funds for renewable energy projects and low-carbon technologies in addition to their deficit spending needs. They are also essential to defending populations against extreme weather events, by supplying countries with finance for climate-resilient infrastructure and disaster recovery.

Yet these instruments are subject to the pressures and strains of climate change themselves. Physical risks can displace populations, render certain areas uninsurable, and damage fixed assets. Transition risks, meanwhile, can disrupt industries and make asset prices more volatile.

Anthropocene Fixed Income Institute research finds a historical direct relationship between these risks and sovereign bond yields – and one that’s getting stronger. This presents new challenges for market participants – and potentially opportunities, too.

Growing influence

The climate factors we have explored are exerting a growing influence over bond performance. Buyers who do not appreciate or understand these are likely to end up mispricing sovereign risk, with potentially painful consequences for their portfolios.

This isn’t conjecture. The data tells the story. We constructed a quantitative regression model to understand what drives bond yields and applied it to a universe of over 2,600 instruments issued by countries from all over the world in the last 10 years. This revealed that climate was a meaningful driver of historical bond yield variations, even when controlling for credit and economic factors. For example, in our historic analysis among Western Europe sovereigns, an annual increase of one million tonnes CO2 (around the annual emissions of the Seychelles) was associated with a wider bond yield by 0.14bps.

Interestingly, the influence of these factors has grown over time. Our analysis found that the importance of climate factors to explaining sovereign yields increased six percentage points over six years, from 33% to 39%. If this trend continues, climate risks – and governments’ responses to them – will play an ever more important role in defining sovereign bond performance. This means fixed income investors accounting for climate factors in their investment strategies will be better prepared to navigate sovereign markets going forward than their less clued-in peers.

Economic readiness and adaptive capacity

Let’s dig into the climate factors themselves. The two most significant climate variables are: one, the economic readiness of a country’s business environment to accept investments that address climate change and the energy transition, and two, its ‘adaptive capacity’, meaning its overall ability to adjust to, and reduce damage from, climate events.

This suggests that the physical impacts of climate change – extreme storms, floods, and temperature swings – and the ways in which they can impair national income, are relevant to the pricing of sovereign risk. This makes intuitive sense. A country where large swathes of the economy are knocked offline by climate disasters, and without the resources to bounce back quickly, is one that’s more likely to struggle to make debt repayments. Last year, the island nation of Grenada became the first country to pause debt repayments using a built-in suspension clause in a sovereign bond after suffering the wrath of Hurricane Beryl.

Tellingly, the relationship between sovereign yields and climate factors varies by region. This is to be expected, as countries have different degrees of climate risk exposure and vulnerability. Moreover, some have embraced climate-friendly policies, whereas others have slow-walked them – or neglected them entirely.

For example, we find that sovereign bonds out of Western Europe are more sensitive to their issuers’ emissions profiles. Higher absolute emissions equate to higher bond spreads, albeit marginally, while this does not seem to be represented across the full population. This likely reflects the more progressive climate policy environments these countries operate under, where pollution is discouraged, even penalised, as witnessed in recent climate litigation cases.

When looking at the Southeast Asia region, even though the regression model seems to give a strong fit, digging deeper shows very unintuitive relationships, such as higher vulnerability being associated with lower yields. This suggests the market has not yet digested climate risks, which in turn presents a risk of a re-pricing.

An incomplete story

Our findings suggest the story of climate factors and sovereign yields is incomplete. Some of the relationships uncovered were weaker than one might expect or trended in unintuitive directions. This suggests there is some way to go before climate risks and opportunities are maturely integrated into pricing.

As things stand, though, we can be confident in saying climate does play a role, and one that looks set to get bigger. The train is leaving the station – but there is still time to get on board. Investors have a window in which to integrate climate realities into their sovereign risk assessments.

They shouldn’t miss it.

The post Time for Sovereign Investors to Get on Board appeared first on ESG Investor.