For decades, investment managers considered ESG analysis to be a discretionary add-on to the traditional approach. A take it or leave it, not to be sworn into the research fold.

But as investors increasingly seek to incorporate ESG research into investment decisions – hoping to align their investment outcomes with their sustainability goals – fund managers are having to adapt.

Equity markets were the earliest and fastest adopters of ESG research, with corporate bond markets following suit, alongside the establishment of sustainable investing principles. However, ESG and sustainability approaches are still relatively less developed in other segments of fixed income markets, particularly sovereign bonds which comprise around 65% of global fixed income’s investible universe.

As fund managers move to fully integrating their ESG strategies, with fundamental and ESG teams now working symbiotically rather than independently, operating within a robust and dynamic investment framework is proving key to unlocking the potential of global sovereigns.

Within this framework, investors are moving away from the traditional ‘building blocks’ approach to constructing their clients’ portfolios; instead, they are utilising flexible global strategies that can respond agilely to ESG-driven investment opportunities.

Creating the framework

The middle ground between ESG and fundamental analysis is progressively shrinking as fund managers realise investment research cannot take place in a vacuum, as factors that were once considered to be uniquely fundamental or uniquely ESG are, in fact, increasingly overlapping.

Where fundamental analysis, by definition, measures a security’s intrinsic value through examination of related economic and financial factors, ESG’s long-overdue arrival in the investment space has inevitably jolted fund managers out of this tunnel vision and provided an important and accretive lens to view risk and identify opportunities.

Unlike corporates, harmonised data is available for every sovereign on the planet thanks to comprehensive in-house dashboards combined with third-party metrics. Freedom House, the International Energy Agency and the World Bank’s Sovereign ESG Data Portal, amongst others, can all contribute to form a quantitative framework for assessing a country’s ESG credentials, both as of today and momentum over time.

With this data at a fund manager’s fingertips, they can holistically assess and compare the ‘investability’ of any sovereign in the world.

Such vast levels of data, however, require a qualitative touch, which is where the framework really comes into its own. The fund manager who is looking holistically at the risks and opportunities can truly cast the broadest net to pull out an attractive opportunity.

Recognising investment potential

Indonesia is one of the world’s fastest growing emerging markets. In 2017, the country announced its goal of integrating low-carbon, green growth into its national development strategy, setting a clear ambition for long-term sustainability.

At face value, Indonesia may not appear an obvious ESG frontrunner, but excels in its economic opportunity and education initiatives, with the latter driven by a constitutionally mandated 20% spend on education. The two factors are inherently linked to future potential, with a continually strong focus on education increasing Indonesia’s ability to not only capitalise on growing economic opportunity but also align with the global shift towards sustainable investment.

Combined with its COP26 pledge to decommission a quarter of its coal capacity by 2030, Indonesia’s potential to build up its human capital by creating greater economic opportunity and advancing education outcomes may improve its ability to transition its economy away from natural resource-intensive industries.

This qualitative analysis overlay enables fund managers to draw better conclusions across the ESG dimensions, which are often absent in a purely quantitative analysis of the data.

Executing the approach

Integrating ESG analysis into sovereign debt research is the natural evolution of sustainable investing in global equity and fixed income markets, but such evolution is only possible if a robust framework joins in on the journey, one that incorporates both quantitative data with qualitative assessments.

The framework is just as important as the investment itself, and this framework is now fit for ESG purpose and ready to propel fund managers into sovereign debt territory, broadening the investible universe for fixed income and, more importantly, generating returns and real-world impact.

ESG factors are becoming increasingly economic in how they influence bond performance, and it’s about time investment research caught on.