ESG and Sovereign Risk: What is Priced in by the Bond Market and Credit Rating Agencies?

In this paper, we examine the materiality of ESG on country creditworthiness from a credit risk and fundamental analysis viewpoint. To address this, we consider a granular set of 269 indicators within the three ESG pillars to determine what the sovereign bond market is pricing in. From this set of ESG metrics covering the 2015-2020 period and 67 countries, we first determine the ESG indicators that are most relevant when it comes to explaining the sovereign bond yield, after controlling the effects of traditional fundamental variables such as economic strength and credit rating. We also emphasize the major themes that are directly useful for investors when assessing the country risk premium. At the global level, we notice that these themes mainly belong to the E and G pillars. Those results confirm that extra-financial criteria are integrated into bond pricing. However, we also identify a clear difference between high-and middle-income countries. Indeed, whereas the S pillar is lagging for the highest income countries, it is nearly as important as the G pillar for the middle-income ones. Second, we determine which ESG metrics are indirectly valuable for assessing a country's solvency. More precisely, we attempt to infer credit rating solely from extra-financial criteria, that is the ESG indicators that are priced in by credit rating agencies. We find that there is no overlap between the set of indicators that predict credit ratings and those that directly explain sovereign bond yields. The results also highlight the importance of the G and S pillars when predicting credit ratings. The E pillar is lagging, suggesting that credit rating agencies are undermining the impact of climate change and environmental topics on country creditworthiness. This is consistent with the traditional view that social and governance issues are the main drivers of the sovereign risk, because they are more specific and less global than environmental issues. Finally, taking these different results together, this research shows that opposing extra-financial and fundamental analysis does not make a lot of sense. On the contrary, it advocates for greater integration of ESG analysis and credit analysis when assessing sovereign risk.