Sovereign Bond Yields and Country Governance


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.


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.

Prospects for the Chinese Economy


The economic prospects of China have been a subject of extensive debate among global media outlets and economists. Opinions range from optimism to pessimism. Two months ago, Martin Wolf, a senior columnist at the Financial Times, presented a thought-provoking article titled “We Shouldn’t Call ‘Peak China’ Just Yet.” In this piece, he offers a well-rounded perspective on the challenges and potential advantages facing China.

Wolf’s argument can be neatly segmented into three key areas. First, he provides insights into China’s current GDP per capita. Remarkably, China’s GDP per capita stood at a mere 2% of the United States’ 42 years ago. After approximately quadrupling, it reached 28% of the US in 2022, equivalent to about half of Poland’s GDP per capita. Should China attain Poland’s level, its total GDP would surpass that of both the US and the European Union combined. To provide context, South Korea’s GDP per capita in 1988 was similar to where China stands today. It took South Korea 19 years to double its GDP, reaching Poland’s current level, with the challenge of the Asian financial crisis in between. If China follows a similar trajectory, doubling its GDP per capita within 19 years, it may match Poland’s level in the 2040s.

Second, he acknowledges the concerns of investors regarding China’s economic prospects. Historically, China’s economic growth has been heavily reliant on fixed asset investments, notably in the real estate sector. Any measures to curtail the real estate industry are bound to affect the broader economy and amplify the vulnerabilities in the financial system. When compounded with factors like an aging population, tense international relations, and other variables, these issues do raise valid short-term concerns.

Third, Wolf emphasizes that investors should not be overly pessimistic about China’s economic outlook. He draws parallels with South Korea, which navigated a debt crisis in 1982 and the Asian financial crisis in 1997. During these periods, many held bearish views on South Korea’s economy. However, post-crisis, South Korea’s economy continued to thrive.

At the end, Wolf also pointed out that it is worth remembering the strengths of China, such as the nearly 1.4 million engineer graduates each year, a strong entrepreneurial culture, and leadership in certain fields, like electric vehicles. Wolf believes that China’s technology sector has long been ahead of Europe.

Beyond Wolf’s well-reasoned arguments, there are additional economic advantages that China can leverage. As specialized fund managers in China, we’d like to underscore a few more strengths.

First, China’s current infrastructure surpasses that of many emerging countries and remains competitive even when compared to developed nations. This positions China as an attractive destination for foreign investment. Once foreign investors regain their confidence, China’s appeal will shine once more.

Second, on a global scale, only the Chinese market boasts a level of uniformity and scale comparable to the US. China’s single legal system, tax structure, consistent trade rules, and shared language across the nation make it favorable for businesses. This uniformity enables companies in China to enjoy economies of scale, resulting in higher returns on investments compared to smaller countries. Companies that excel in the Chinese market also gain a competitive edge in dominating other markets. This phenomenon is why the US hosts more large multinational corporations than any other country in the world. We firmly believe that China has the capability to nurture more multinational corporations in the future.


Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.