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No one will argue on the importance of sovereign bonds for healthy portfolio construction, both in terms of size and weight. However, when it comes to sustainability, the European regulator largely leaves them aside, despite the key role sovereign debt can play in the financing of sustainable and inclusive growth. We explain why.
Ruling out sovereign bonds from a sustainable approach is not an option. The lack of precise and detailed regulation should not be an excuse to stick to the current definition. It is rather a reason to plead for a disciplined, rigorous, and credible approach to include sovereign bonds as important contributors to sustainable development in the same way as instruments issued by the private sector. Today we are witnessing an important debate at the European level on the classification of sovereign bonds in the European Commission’s ESG scale:
First, there is a need to define to what extent sovereign bonds integrate ESG factors, promote environmental and social characteristics or even pursue an environmental and social objective. Moreover, sovereign bonds are not covered by the European Taxonomy and can therefore –from a technical point of view— impossibly meet the environmental objectives set out in the taxonomy.
Secondly, the so-called “principal adverse impact indicators” specific to the asset class are limited in number and open to interpretation, such as the social indicator on the number of countries in social violation.
Finally, let’s have a look at the last and third option for investors subject to MIFID to express their sustainability preferences: How should one clearly distinguish and measure the environmental and/or social objectives of a country (let alone define appropriate KPIs)?
Yet, it is obvious for a multitude of reasons that sovereign bonds should be recognised in their own right as a vehicle to finance a sustainable and inclusive economy.
Firstly, sovereign bonds represent a major asset class and remain a key pillar of institutional investors’ portfolio construction.
Figure 1: Global capital markets by asset class
Source: Value in Trillion euro (as of June 30, 2022). Based on the market value of the following indices (no adjustments): Dow Jones US Total Stock Market Index, MSCI World Excluding United States Index, MSCI Emerging Markets Index, Global Global Inflation Linked Index, Bloomberg Barclays Global Aggregate Index, Bloomberg Barclays EM Local Currency Government Index, Bloomberg Barclays EM Hard Currency Aggregate Index, Bloomberg Barclays Global High Yield Index
Second, when defining the Sustainable Development Goals as a follow-up to the Millennium Development Goals to finance the sustainable development of states, the private sector has been called upon to supplement public funding, considered insufficient on its own to meet all the needs. In the same logic, the current, sole focus on private funding will not be sufficient to foster sustainable development. Both private and public funding need to be recognised as full contributors to the cause.
Lastly, a majority of states have formally committed to the 2030 ambitions, whether through the 17 UN Sustainable Development Goals or through the signing of the Paris Agreement for a Just Transition to a Low Carbon Economy. It is only natural that they should align their bond issues accordingly.
Therefore, our conclusion is that a portfolio of sovereign bonds, subject to a strict and rigorous approach to responsible investment, can and should serve a sustainable purpose of promoting environmental and social attributes and objectives. How?
Through a robust and critical sustainability analysis model, it will be possible to identify the level of advancement of countries as well as the strengths & weaknesses and progress made by each country through an engaged dialogue. By integrating the 17 Sustainable Development goals upstream in the investment process, the portfolio will naturally be called upon to align with the UN’s target for sustainable development.
Defining KPI’s at portfolio level, will help to analyse and evaluate the impact based on a number of measurable environmental, social or governance criteria such as respectively carbon footprint or countries’ efforts to decarbonise; social criteria to encourage better respect for fundamental values such as human rights or labour rights; or governance criteria to encourage the fight against corruption or better respect for civil rights and individual freedoms.
Green Bonds and similar instruments are obviously clear tools for the promotion of environmental and/or social objectives. Their objectives are clearly defined and can be monitored from the beginning of the issuance until the maturity of the bond. Provided, of course, that the green bonds (or similar instruments) meet the criteria of a true green bond: i.e., with the clear use of proceeds (eligibility of the projects, decision-making process), disclosure of documentation, approved verifier and management (tracking) of the proceeds.
Finally, let’s not forget engagement, which is at the heart of the sustainable investment approach. It is through engagement that exchanges on best practice take place. It is also through engagement that governments are made aware of sustainability issues. It is essential that sovereign debt investors demonstrate how key these criteria are to attract investments. It is also crucial to encourage sovereign debt issuers to address sustainability concerns, which are central to an investment mindset.