Beyond Credit Ratings: The Role of (E)SG in Sovereign Debt Investments

Abstract: The study investigates the correlation between ESG performance and sovereign bond yield spreads using regression analysis. The results reveal a significant negative correlation between the Governance and Social indices and bond spreads, emphasising the importance of good governance practices and social stability in reducing the risk of sovereign debt default. However, the Environmental index does not exhibit a significant correlation, possibly due to a time-horizon mismatch and limited selection of environmental variables. Integrating ESG performance, particularly Governance and Social factors, alongside traditional credit ratings can provide investors with a comprehensive view of risk in sovereign debt investments. Monitoring ESG signals and excluding the worst ESG performers from portfolios may help reduce volatility while maintaining portfolio characteristics. The study acknowledges limitations, such as time horizon mismatch, omitted variable bias, and data quality, suggesting avenues for future research to address these limitations and enhance the robustness of the analysis.