The credit risk profiles of sovereign issuers are integral to the low-carbon transition. Sovereigns with high creditworthiness have a lower cost-of-capital, and can therefore borrow more cheaply to invest in climate-friendly projects and infrastructure.
Climate risks have the potential to undermine sovereign creditworthiness, however. Physical risks can displace populations, render certain areas uninsurable, and damage fixed assets. Transition risks, meanwhile, can disrupt industries and make asset prices more volatile.
In this research note, we uncover how climate factors drive sovereign bond yields using a comprehensive regression model applied to a dataset of over 2,600 instruments.
Our analysis finds that climate readiness and vulnerability are significant drivers of bond yields, although they are secondary to credit and technical factors, and this significance has been increasing with time.
The factors are more significant in two sub-populations, ASEAN and Western Europe. However, while some of the relationships between climate factors and bond yields make intuitive sense, others are confounding. For example, we find that emissions are the least important climate factor to bond yields, and that one measure of sovereign emissions is correlated with tighter – not wider – spreads. This suggests that climate transition risk is not yet being priced intuitively by the market.
Kamesh is an experienced credit derivatives and bond trader who leads the development of AFII’s portfolio analytics tool, Co₂liseum. He was previously a market maker and credit analyst at NatWest Markets, and holds a PhD in deep learning.
Based in London, Jo leads AFII’s research and a global team supporting fixed income investors as they align their portfolios with climate and sustainability goals. She joined AFII after 18 years in fixed income markets at JPMorgan.
