Since the outbreak of the Russia-Ukraine war, investors have broadened their focus on the “G” in ESG (Environment, Social, and Governance) to the country level. The question is how to define the country-level “G” and how the quality of a country’s governance affects investment returns.
Research on global sovereign bonds might shed light on these questions. A fundamental assumption is that a country’s degree of democracy and freedom correlates with its sovereign bond yield spread. The results do show a correlation between the two, but surprisingly, other factors have a more substantial impact on sovereign bond yield spreads compared to the degree of democracy.
Using the World Bank’s “Worldwide Governance Indicators” as a starting point, there are basically six indicators: “Voice and Accountability”—representing the degree of democracy in a country, “Political Stability and Absence of Violence/Terrorism,” “Government Effectiveness,” “Regulatory Quality,” “Rule of Law,” and finally, “Control of Corruption.”
Plotting the above six indicators against per capita Gross Domestic Product (GDP) reveals a clear positive relationship: countries with higher governance scores also have higher per capita GDP levels. In simple terms, developed countries exhibit better governance than emerging economies.
However, when looking at sovereign bond yield spreads, the relationship is not as straightforward. The most significant factors affecting spreads are “Government Effectiveness” and “Regulatory Quality,” with a correlation of -0.47. In contrast, the correlation of “Voice and Accountability,” representing the degree of democracy, is only -0.19. Regardless of the sign, the closer the correlation number is to zero, the lower the relationship. In this case, a country’s degree of freedom has a smaller impact on its bond yield spreads than the other two factors.
This is understandable because bond investors’ main focus is on a sovereign country’s repayment ability. If a country has poor governance, with internal political turmoil and insufficient protection of property rights, even if the degree of freedom is high, the country’s repayment ability will be in doubt, resulting in a relatively higher required yield for their sovereign bonds. On the other hand, some resource-rich countries, such as oil-producing countries in the Middle East, may have a lower degree of freedom. Still, the money obtained from selling resources ensures their debt repayment ability to some extent.
Comparing only emerging markets, countries with the highest degree of democracy scores, such as Uruguay and Chile, have yield levels similar to countries with the lowest scores, such as Saudi Arabia, both around 1 to 2%. Conversely, some countries in the middle of the democracy and freedom ratings, such as Mozambique and Nigeria, can have yields as high as 8-10%. The reasons behind this likely relate to other variables in the governance indicators, such as government effectiveness and the control of corruption.
Some ESG sovereign bond investors define a country’s governance level based on its level of democratic freedom. Still, surveys in some emerging markets show that, especially in relatively poorer countries, although people generally welcome long-term improvements in democratic freedom, they often also value short-term economic improvements. Therefore, from a purely investment perspective, which factor best represents the “G” at the country level still requires deeper thoughts and discussions.
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