The EDHEC-Risk Institute recently published this study on ESG (Environment, Social and Governance) risks in Sovereign Bond Portfolios as part of the “ETF, Indexing and Smart Beta Investment Strategies” Research Chair at the Institute, in partnership with Amundi ETF, Indexing & Smart Beta.

The study explores the impact of ESG factors on sovereign bonds risk and return from an investor perspective and, in particular, examines how to measure and manage ESG risks in sovereign bond portfolios and their implications for portfolio strategies.

Firstly, it provides an assessment of the impact of ESG on risk and profitability, being the main objective of the first part of the work being to analyze whether cross-sectional differences in risk and return of developed or emerging country sovereign bonds can be partially explained by cross-sectional differences in A, S or G ratings.

It then explores the implications for sovereign bond portfolio management by analysing how to measure and minimise the opportunity costs associated with the introduction of ESG constraints relative to a comparable unconstrained sovereign bond portfolio strategy.

Such opportunity costs can be measured in terms of a possible increase in risk and reduction in performance and/or in terms of an increase in tracking error relative to the benchmark.

The authors finally provide evidence that ESG-boosting strategies in sovereign bond markets can be used to further reduce some of the opportunity costs, and conclude that sound risk management practices are of vital importance to enable investors to incorporate ESG constraints into their investment decisions at acceptable costs.