How to use ESG to assess state government bonds

Pendal’s ESG scorecard measures credit risk on state government bonds. MURRAY ACKMAN explains how it works

• ESG factors help understand risk of bond downgrade
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

IF you’re investing in state government bonds, you’re probably not too worried about default.

But you might be concerned about a potential credit downgrade – which could result in lower demand for a bond and a drop in its value.

Pendal’s income and fixed interest team has a tool to assess the ESG credentials of state governments – which can help highlight credit risks that might lead to ratings downgrades.

The Australian States SDG Index assesses how each state is addressing the UN’s Sustainable Development Goals – a list of the world’s biggest problems.

The ACT, Tasmania and South Australia lead the index, while Western Australia, Queensland and the Northern Territory lag, says Pendal ESG credit analyst Murray Ackman.

“People always talk about default — the risk of not getting your money back,” says Ackman.

Find out about

Regnan Credit Impact Trust

Read more

“But that’s not all we’re looking at.

“There would have to be something catastrophic for a state government not being able to service its debt.

“What does have an impact on your investment is credit downgrades.”

How it works

The index scores the states on 70 indicators across 16 environmental and social themes.

It assesses how states perform on factors like healthcare and education spending, climate action, water and sanitation and justice and strong institutions.

Ackman uses the example of ratings agencies downgrading Queensland more than a decade ago after it slid into deficit on the back of a big spending program on water security.

“There was a longstanding underspend on water security, so a lot of money had to be spent on a desalination plant. ESG can give us an early warning sign of these kind of issues.”

Today, Ackman says there are signs of underspending in Victoria on health and well-being and in the Northern Territory on justice and strong institutions.

These could flag future problems, he says.

On the upside, the index shows strong environmental scores in the ACT and Tasmania, both already using a high proportion of renewable energy which reduces the risk of the energy transition.

Ackman says ESG scoring also provides an opportunity to engage with governments and seek to directly drive change — even although governments can be less responsive than corporations to the views of the investment community.

“Engaging with a company can be pretty obvious — one has better human rights policies, another might have good oversight of their supply chain and slavery. You can compare the two and make a decision to engage or divest.

“But government bonds are different. Commonwealth government bonds are more than half the index for some of our fixed interest funds.

“We can engage — and we’re pushing for green issuance and we want to see new projects being funded — but we don’t realistically have the opportunity to divest. Having genuine influence over an issuer would require being willing to walk away.”

He says Pendal’s ESG scoring also allows investors to be sure their money is being invested in line with their intentions.

“Our investors want their values reflected in the investment decisions that we make.”