Our century is characterised by the two separate megatrends of ageing populations and climate change. Both are without example in recent history. And both will take decades to fully unfold. 

The need to gauge the impact on credit risk is becoming more pressing. It is nowhere more urgent than in the asset class that is the ultimate backstop for all challenges and calamities that may befall us: government bonds. 

The pandemic made abundantly clear that the buck always stops with governments. When the social and economic fabric is under strain, the state will be called to the rescue. Public finances and sovereign ratings will feel the pain. 

Investors searching for long-term indicators of sovereign credit risk find a deep void. There aren’t any. Credit agencies have coyly tiptoed into appraising the possible impact of climate change and ever larger cohorts of seniors, but it seems they pulled back. Maybe they were too concerned about what they saw. 

S&P warned in 2016 that unless governments take decisive action, burgeoning old age-related spending would erode public finances to such an extent that the G7 sovereign debt would have to be downgraded to the brink of junk status before 2050. In 2018 Moody’s arrived at similar conclusions: debt affordability will be at risk. 

As for climate change, simulations by economists at Cambridge university based on S&P’s sovereign methodology suggest that unabated global warming will lead to significant cuts in ratings. The average downgrade of G7 sovereigns plus China would be over 3.5 notches by the end of the century. Canada, China and the US would be worst affected. 

Those are near-worst-case scenarios. Yet even under a more robust policy reaction to climate change, the trend of sovereign ratings drifting downward will persist. 

For example, the unweighted average S&P rating of the G7 countries dropped by an average of 2 notches since 2000. These pre-pandemic downgrades occurred even without the added stresses of climate change and ageing. Add those to the mix and it is easy to see how the drop in sovereign ratings will continue, if not accelerate. 

Right now, there is no measure that would describe this downgrade risk. The agencies’ “long-term” ratings supposedly reflect credit risk up to 10 years. That time horizon is designed to assess fundamental risks through an economic cycle. But the changes to our climate and demographics are not cyclical. They are structural. And they are long term. In fact, the agencies’ time horizon may be fictitious, anyway: in real life, their economic and financial forecasts rarely extend beyond three years.

But whether the time horizon is 10 years or three, it is too short to incorporate longer term credit constraints. It is simply not credible to assign a default probability to a five-year bond identical to that of a 50-year bond. The risks are plainly more elevated for longer-term debt. 

The time has come to make long-term ratings truly long term. One solution would be a regulatory requirement for agencies to issue “truly-long-term” sovereign ratings, distinct from their current so-called long-term ratings. Failing to do so would bar them from rating government bonds above a certain initial maturity, eg 10 years. 

This differentiation in rating time horizon would mirror the IMF’s approach to debt sustainability analysis. It runs one assessment for the medium term (up to five years) and a long-term projection (up to 20 years). 

It is likely that the agencies are fully aware of their myopic method. So why have they not proactively extended the time horizon? Inertia is certainly one factor. But change is also not in the agencies’ (or sovereign governments’) interest. 

Change would require significant investment into new analytical skills without a plausible prospect that issuers will recompense the agencies for the added effort. Even less so, as the message embodied in a truly-long-term rating is unlikely to be a happy one. There is no discernible commercial upside. 

The Financial Stability Board should therefore provide the required leadership. Through its previous work on climate-related financial disclosure, the FSB has the competency and the credibility to shift the debate. Changes like the introduction of truly-long-term ratings could take years until full implementation. In the meantime, the unaccounted for credit risks will mount inexorably. 

We now have an urgent short-term need for long-term ratings. The risks can be calculated. Investors, policymakers and citizens have a right to know.

This blog was first published as a Market Insight opinion article on July 8, 2021 in the Financial Times.

As challenges of climate change and ageing mount, investors need benchmarks for risks in decades to come.

The case for ‘truly-long-term’ debt ratings

Sovereign defaults have climbed to multiyear highs since the pandemic’s emergence. And defaults can take many forms. Identifying and quantifying defaults can be challenging if we go beyond the largest and most visible episodes.

David T. Beers, Senior Fellow at the Center for Financial Stability and former head of S&P’s sovereign ratings, will present the latest trends on why and how sovereigns default, and what he expects in the coming years. David will also reveal the findings of the upcoming edition of the annual Bank of Canada/Bank of England sovereign default database. Built in 2014, this has become the go-to resource for research on sovereign defaults.

When defaults happen, the lack of clarity of a sovereign’s financial obligations often severely slows down restructuring proceedings. This delay adds to the crisis in the debtor country and can lead to additional losses for creditors.

Prof. Rym Ayadi, President of the Euro-Mediterranean Economists Association and Professor at the Business School of the City University of London, will discuss the progress and obstacles in enhancing debt transparency in emerging and developing countries.

Presentation by David Beers on the sovereign default database update: Link

Quick link to webinar materials and video

Webinar: Sovereign defaults and debt transparency: what’s ahead?

While it would be premature to declare the COVID-19 pandemic almost over, the acceleration of vaccination rates has allowed many of us to dare to believe we’re at least at beginning of the end. And as the restrictions on people’s daily lives begin to fall away, the global economy has also gathered pace and appears to be on firmer ground than it was a year ago. 

However, if we take a global perspective, the massive impact of the pandemic continues to rear its head. 

The latest update to the Sustainable Development Goal (SDG) Index, which provides a country-by-country SDG progress summary, paints a startling picture of the consequences of COVID-19. The authors write that, for the first time since the SDGs were adopted in 2015, the SDG Index deteriorated in 2020 compared to 2019, as shown in the chart below.

Guillaume Lafortune from the UN Sustainable Development Solutions Network (SDSN), author of the SDG Report 2021, said, 

“The COVID-19 pandemic is a setback for sustainable development everywhere. For the first time since the adoption of the SDGs by the global community in 2015, the world average SDG Index declined in 2020. This was largely driven by the rise in poverty rates and unemployment. The SDGs provide the right vision for building ‘forward’ better—green, digital, and resilient. Developing countries require additional fiscal space to finance the emergency response to the pandemic and the investment-led recovery.”

The decline in the SDG Index means that we’re now further away from achieving the SDGs than we were before the pandemic. Worse, the deterioration is also very likely to have been underestimated, as many of the SDG Index input statistics were unavailable for the latest update due to reporting lags. 

The setback is especially acute for SDG 1: No Poverty, which, as shown below, shows a significant overall decline compared to the previous SDG Index update.

The same pattern is reflected in the SDG 1 scores for every region except Latin America & the Caribbean and Middle East & North Africa, whose scores had already been deteriorating for several years before the pandemic. Much of the increase in poverty in Latin America can be attributed to the multi-year Venezuelan economic and social crisis. 

Looking at the league table of the SDG Index is an unsurprising affair. The top ten countries are all European, with the Nordic countries occupying four spots in the top ten and all of the top three. 

But with a score of 85.9, even the SDG Index’s top-ranked country, Finland, is still a way off achieving all of the SDGs. While it’s important to note that the SDG Index indicators aren’t fully aligned with the official SDG indicator targets, it’s still, in our view, the best available approach to measuring progress towards achieving the SDGs. 

There are also no surprises to be found at the other end of the SDG Index, which remains dominated by African countries such as Central African Republic, Chad, Somalia and South Sudan. Here, scores in the 40s and even the 30s indicate a long road ahead. 

As we wrote in a previous blog about the challenges of constructing ESG and SDG indexes, (Link to blog post), there is typically a broad consensus around which countries should occupy the top- and bottom-most spots. The middle-rankings, though, are more contentious. 

For example, New Zealand and Belarus have broadly the same score, and Singapore ranks only 76th out of 165 countries while Ukraine ranks 36th, just below the United States. Do these rankings make sense? As is often the case, the answer is: it depends on what you plan to do with the information. 

At CountryRisk.io—as mentioned earlier—we find the SDG Index to be the best available approach to ranking countries in terms of their progress towards achieving the SDGs. That’s why we integrate the SDG Index into our platform, as illustrated in the screenshot below. You can register for CountryRisk.io for free here.

When it comes to other use cases, such as constructing a portfolio of government bonds, deciding how to use such data becomes more tricky. Clearly, we shouldn’t make direct use of it by weighting our portfolios towards those countries with the highest SDG Index scores, not least because this wouldn’t be in keeping with the spirit of sustainable finance—after all, the countries most in need of capital to promote sustainable development will also be those that score lowest. 

And yet, the opposite approach—weighting our portfolios towards those countries with the lowest SDG scores and hoping for more significant progress—also doesn’t sound like a good investment strategy. Meanwhile, a third option is to favour countries that show the strongest positive momentum in the SDG Index. 

The chart below encapsulates the challenge of using SDG data in the context of sovereign credit risk. Here, we can see only a very loose relationship between countries’ SDG Index scores and their sovereign ratings. While higher-rated countries tend to have better credit ratings, on a more granular level, the SDG Index isn’t much help when it comes to differentiating between rating buckets.  

Integration of SDG/ESG factors into sovereign credit risk

But there is a fourth strategy, one that we at CountryRisk.io find to be well-suited to sovereign credit risk assessments: the fully integrated approach. 

 It’s important to stress that our objective is to assess the credit default risk of government bonds. We do this by identifying those indicators that impact credit risk, which includes a range of commonly used indicators such as economic wealth (i.e. GDP per capita), government debt & affordability ratios and institutional quality. But we also integrate ESG indicators, according to two principles:

Empirical evidence: Can we show statistically that an indicator is useful in assessing and predicting sovereign default risk? In short, we conduct an empirical financial materiality test. 

Theoretical considerations that link a given indicator to the key drivers of debt (un-)sustainability: indebtedness and wealth (financial assets, environmental wealth, social/human capital), future growth prospects, fiscal outlook, interest rates or general risk premiums. 

By applying these two principles, we end up with a smaller set of ESG indicators than the SDG Index’s. We group these indicators into six categories:

Labor market and social safety systems  

When we compare the CountryRisk.io ESG score with the SDG Index, we see some correlation but also some dispersion due to the integration of standard sovereign risk variables. As a result, while Finland and Central African Republic are, respectively, the top- and bottom-performing countries in the SDG Index, this isn’t the case from a sovereign default perspective. 

Meanwhile, if we only compare the E- and S-components of our risk score with the SDG Index, we get a much stronger correlation. 

Interestingly, governance indicators like rule of law, corruption and regulatory quality show a weaker correlation with the SDG index. While such indicators are among the most important for sovereign credit risk assessments, they’re only reflected in the SDG Index indirectly. 

A big problem with integrating environmental and social risk factors into sovereign credit risk assessment is data quality, in terms of timeliness, country coverage and methodological consistency over time. When we look at the World Bank SDG database, we find that, for many indicators, the latest data are from 2016 or even older. Data availability is somewhat better for the World Bank ESG database that is more limited in terms of indicators but we are far away from data timeliness that we are used to in other ares like GDP reporting. 

When it comes to our own CountryRisk.io ESG Sovereign Risk Score, we’re acutely aware of these data quality issues. That’s why we recommend it for two use cases:

To conduct more comprehensive due diligence. 

Our rating model incorporates not only most of the quantitative indicators found in the Risk Score but also many qualitative factors that focus on the forward-looking assessment of government policies, from fiscal aspects to carbon-neutral and inclusive education policies. The authors of the latest SDG Index publication also stress the importance of incorporating an assessment of the commitment and quality of government policies:

“The SDG Index and Dashboards focus on internationally standardized outcome statistics. Due to data gaps and time lags in international reporting, national policies and commitments must also be considered in gauging a country’s efforts to achieve the SDGs.”

Such an integrated approach that combines quantitative and qualitative aspects is time-consuming and requires knowledge about a wealth of topics. But while there’s no shortcut to a diligent analysis, it’s possible to avoid some of the drudgery, such as model building & maintenance and data wrangling. At CountryRisk.io, our goal is take care of the tools, models and data our members need, leaving them to focus on analysing country risk. 

Strong headwinds en route to achieving the Sustainable Development Goals

Webinar: Sovereign defaults and debt transparency: what’s ahead?

Jenny Asuncion
Jul 06, 2021

The case for ‘truly-long-term’ debt ratings

Strong headwinds en route to achieving the Sustainable Development Goals

Written by:
Jenny Asuncion

Webinar: Sovereign defaults and debt transparency: what’s ahead?

Jenny AsuncionJul 06, 2021

The case for ‘truly-long-term’ debt ratings

Strong headwinds en route to achieving the Sustainable Development Goals

Written by: Jenny Asuncion

Jenny Asuncion
Jul 06, 2021

Written by:
Jenny Asuncion