By Richard Davies, Director, Fixed Income and Multi-Asset Product Management, Lazar Karapandza, Senior Analyst, SI Research, and Jullien Moussavi, Senior Research Lead, Sovereign ESG
While few would question the importance of applying ESG considerations to government bond allocations, there’s a continuing philosophical debate about how best to do it. ESG integration in a global sovereign portfolio can present significant challenges—and come with several tradeoffs—so it’s perhaps not surprising that no consensus has been reached on the complex issue of how to approach it.
For investors looking to integrate ESG in sovereign bond allocations, the ongoing debate over investment approach has meant there’s been a relative lack of ESG government bond indexes in the market. Drawing on the factor tilting we’re already using for our FTSE Global Factor Index Series, we’ve developed an index that addresses the challenges and tradeoffs associated applying ESG considerations to a sovereign debt portfolio.
ESG and government bonds: It’s complicated
Sovereign ESG integration is gaining momentum as more international organizations and governments are recognizing that climate change has significant implications when it comes to sovereign borrowing costs. And more financial institutions and market participants have also focused on integrating ESG in sovereign risk analysis, giving rise to a number of global initiatives designed to support the trend.
However, despite growing global interest in applying ESG factors to government bonds, constructing an ESG government bond index can come with several challenges. For one, issuers’ ESG scores can be clustered together, particularly in developed market bond portfolios. Market-weighted global debt indexes such as the FTSE World Government Bond Index (WGBI) typically have large exposures to a few countries and this concentration presents a challenge for ESG implementation.
Another challenge is the tradeoffs that often come with increasing a government bond index’s ESG performance relative to its underlying benchmark, notably with respect to Active Share and tracking error. As shown, the more we improve the sustainability profile score of the FTSE WGBI, the higher the Active Share, or the percentage of holdings that differ from the benchmark index. And the consequence of taking on more Active Share—and thus more ESG—is higher tracking error relative to the flagship WGBI index.
ESG Improvements come with tradeoffs
Drawing on existing FTSE Russell methodology to address the challenges
At FTSE Russell, addressing the challenges and tradeoffs associated with building an ESG government bond index didn’t have to require reinventing the wheel. We draw on our existing factor tilting methodology to build the FTSE ESG World Government Bond Index (WGBI), but instead of using traditional factors, we treat E, S, and G pillars as factor exposures.
Applying this model to the WGBI, a strategy can adjust its Active Share to control for ESG enhancement. This exposure can be controlled for levels of diversification and take on greater tracking error, while enhancing the ESG value. In the standard FTSE ESG Government Bond Index, ESG Tilts are set at 0.5, a value that keeps tracking error below 50bps. As shown, increasing the tilt strength further results in a higher sustainability profile, but the improvements in sustainability tails off for increases in tilt strength beyond 2.
Balancing higher ESG performance with the tradeoff
Meeting rising demand for ESG government bond indexes has come with the challenge of balancing improved ESG performance with higher Active Share and tracking error. Leveraging our existing factor tilting methodology, the FTSE ESG WGBI takes an innovative approach to addressing these tradeoffs.
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