Since 2011, those countries with higher ESG ratings have seen their CDS spreads fall by more than countries with relatively low ESG ratings, MSCI has found.
This relationship holds for all government bonds, apart from those that have Aaa ratings with CDS spreads below 50 basis points (bps).
The relationship between ESG ratings and credit performance is largest for government bonds with relatively high credit spreads.
Countries with CDS spreads between 100 and 400 bps and low ESG ratings in 2011 have seen credit spreads rise since then, while countries with higher ESG ratings have seen them drop (see chart).
MSCI’s ESG government ratings assess countries’ relative exposure to six environmental, social and governance risk factors (natural resources; environmental vulnerability; human capital; economic environment; political governance and financial governance).
These issues don’t as such relate directly to default risk, but rather to a country’s long-term financial stability.
“For example, poor management of resources could make a country’s economic growth rate unsustainable, and weaken public finances in the longer term. Similarly, weak government institutions could lead to mismanagement of financial resources, and impair both a country’s willingness and ability to repay debt,” says Mervyn Tang, an ESG researcher at MSCI.
Such risks are often not fully priced in, making it worthwhile for investors to take sovereign ESG ratings into account.
Tang suggests ESG country risk is not just an issue for government bond investors, but could also impact other asset classes.
“Sovereign credit risks could be transferred to corporates and financial institutions through a variety of mechanisms, for example taxation and other policy changes, financial market instability and the likelihood of government support,” says Tang.
An increase in sovereign credit spread is also associated with statistically and economically significant increases in corporate spreads, and hence firm’s borrowing costs.
This relationship is especially strong for companies in the financial sector.