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This material was originally published by the UN Principles for Responsible Investment (PRI) on 31 January 2019.
ESG criteria are an integral part of PIMCO’s sovereign ratings analysis and provide important context to our assessment of a sovereign’s creditworthiness. We believe incorporating ESG factors into traditional sovereign analysis helps the identification of credits with potentially lower long-term credit/higher default risk, as well as countries with positive and/or negative ratings momentum. Both are material to the evaluation of sovereign default risk in the medium term and the price of sovereign credit risk in the near term.
A key challenge when considering which ESG factors to consider in sovereign analysis is the issue of potential latent risks, which tend to manifest in the long term and often have indirect effects on creditworthiness. And, when they do, they can have significant binary effects. The Arab Spring in 2011 is an example: Extremely high levels of youth unemployment, income inequality and limited political voice coexisted for decades in what was essentially a “stable disequilibrium.” These initial conditions sparked a sudden and full-blown movement for social and political change across the region. A latent risk emerged rapidly – with profound effects on sovereign credit.
PIMCO seeks to uncover and analyze latent risks in sovereign credit via a multifaceted approach, including:
We find that the combination of the sovereign ratings model, third-party checks, standalone ESG score and scenario analysis provide a better assessment of latent sovereign risks. The ratings model directly includes these risks in our credit assessment, the third-party checks and ESG score act as a flag for issues that are not explicitly incorporated in the ratings, and the scenario analysis provides a framework for thinking about the probability of these outcomes and the consequences should they occur.
This approach has helped PIMCO recognize potential latent risks over the long term and better manage left-tail risks (i.e., less likely events that could have major effects). It enabled us to navigate a challenging environment in the aftermath of the Arab Spring where the political economy of several countries in the region became more uncertain. It also helped us identify sovereigns where similar risks existed. Specifically, it shaped how we approached the social risks associated with the aftermath of the eurozone debt crisis. There we identified in advance the shift towards populist political regimes and the tensions this would create between the core and the periphery economies. As such we took a more cautious approach to adding European risk during the initial stages of the crisis.
Our approach to latent ESG risks has also been a key input in our assessment of political regime changes across the globe including in Brazil, Mexico and Argentina, as well as helping assess where political regimes have remained in place despite these latent risks, e.g., South Africa and Russia. On a more micro level, focusing on events such as strikes, protests and riots have allowed a deeper analysis of government reaction functions that can directly affect sovereign credit risk, e.g., the fiscal concessions made in the aftermath of the truckers’ strike in Brazil made us more cautious on investing in the country as we discounted the chance of pension reform ahead of the October 2018 elections (see Figure 1).
The key takeaway has been to be proactive and continually reassess our investing and credit risk priors in our identification and assessment of latent ESG risks in sovereign credit analysis. While it can be tempting to overlook them given the bias towards near-term material risks, their binary nature and the potential for severe consequences can mean that ignoring them could result in overlooking big risks to portfolios and/or missing important investment opportunities.
Learn more about how PIMCO applies its rigorous ESG analysis to sovereign bonds.
Head of EM Sovereign Credit
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Socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, by PIMCO will reflect the beliefs or values of any one particular investor. Information regarding responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete, and PIMCO is dependent on such information to evaluate a company’s commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. There is no assurance that the socially responsible investing strategy and techniques employed will be successful. Past performance is not a guarantee or reliable indicator of future results.