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Fixing the framework for fixed income

Alexander Jones
Research Associate

Earlier this year, a Ryanair passenger flight heading from Athens to Vilnius was alerted to an onboard bomb threat whilst flying over Belarusian airspace. It was subsequently ordered to make an emergency landing in Minsk, escorted by a fighter jet. However, the true motive behind the forced grounding soon became clear, as political activist Roman Protasevich was swiftly removed from the plane and detained by the Belarusian government.

What does this have to do with investing in bonds?

MORE THAN MEETS THE EYE
In the aftermath of the arrest, the EU imposed a series of sanctions on Belarus, including a ban on European investors from purchasing new debt issued by the Belarusian government. This is not the first time that human rights violations have impacted sovereign bond markets. Fixed income investors have begun to take a more active approach to considering governance, as well as environmental and social factors, in their risk analysis. Environmental, social and governance (ESG) forces are becoming an increasingly significant driver of returns as, for instance, extreme weather events have a greater impact on the performance of the domestic economy. Crucially, sovereign bond investors are a key source of finance for governments, so they have the bargaining power to push policy towards greater ESG risk mitigation.
A HOLISTIC AND IMPERFECT MODEL

We have been building a framework to assess the underlying ESG risks in our sovereign bond holdings (we don’t directly hold any corporate issues), to sit alongside and complement our traditional investment analysis of debt instruments. We have built an internal proprietary model to assist us in identifying and assessing sovereign ESG risks, consisting of country-level indicators to gauge each sovereign issuers’ exposure. It is impossible to perfectly model every individual factor, but our sustainability framework includes a wide-ranging set of measures.

Climate risk may generate the most headlines, but there is so much more to consider beyond just CO2 emissions. We analyse environmental inputs ranging from renewable energy usage to waste recycling, and even population studies assessing physical climate risk in low-lying areas. From a social and governance perspective, indicators are equally broad, touching on health and education, female labour force participation, and measures of political stability and corruption. In total, we assess 14 thematic factors using 37 internationally comparable datasets, for over 180 countries. The output of the analysis is a sustainability score assigned to each sovereign issuer. The model also allows us to identify where dangers for a particular sovereign are concentrated, giving us a basis for areas to focus future engagement.1

One potential issue with this framework is the strong correlation between a country’s ESG score and a country’s level of development. More developed economies naturally tend to have stronger democratic institutions in place, and more stringent social and environmental laws: it is easy for models to over-penalise developing economies.

Transitioning to a greener, cleaner economy won’t come cheap: it will require a large amount of investment

To avoid this, we assess the development of a country’s ESG profile over time, to try to understand which governments have been taking action and making improvements. Our framework allows us to identify the areas in which different governments have been making the greatest strides, and where there is still room for them to catch up. This gives us a more holistic, fairer model, not one conditional on a country’s initial level of wealth.

ACTING ON ANALYSIS

The implementation of this framework is complicated. Some investors have taken the decision to simply ‘dump’ the bonds of high-ESG-risk issuers. According to a recent survey conducted by Morgan Stanley, negative ESG-screening is employed by 45% of investment grade lenders.2 We aren’t sure this is the best option. Using a strict, rules-based, static framework to blacklist countries that fall below a pre-determined grade will reduce the capital available for those most in need of funding for economic, environmental and social development. Transitioning to a greener, cleaner economy won’t come cheap: it will require a large amount of investment (and debt issuance) by governments and corporates alike. Moreover, investors are more likely to blacklist emerging markets, which will increase their borrowing costs, leading to lower growth in these countries and further economic divergence with the developed world.

Another difficulty in excluding poorly scoring sovereign issuers is defining where to draw the line. The US is the world’s second biggest CO2 emitter,3 but with climate change at the centre of President Biden’s agenda, there is plenty of scope for improvement. The US Treasury market is the world’s largest and most liquid bond market; US government debt makes up 39% of the FTSE World Government Bond Index.4 To exclude US sovereign debt from portfolios would require a degree of conviction which has, thus far, eluded most investors.

ONE SIZE DOES NOT FIT ALL
Transitioning to a more sustainable world is highly complex and the sovereign framework we have created is not about binary investment outcomes. Instead, it gives us a three-dimensional understanding of the different sustainability risks facing sovereign debt issuers at a time of growing scrutiny and pressure on governments. This information should enhance our investment decision making and risk management of portfolios and assist us in identifying key areas for engagement with policy makers. In recent years, we have engaged with national policy makers in the UK and overseas on topics from future debt issuance to sustainability regulations and disclosures. Market-wide fixed income ESG

analysis and engagement may still be in its infancy, but it has the potential to have a powerful impact on some of the world’s most pressing issues.

2021 Q4 report
In our latest quarterly report, Research Associate Alexander Jones explores the framework we have designed to help us achieve a holistic understanding of fixed income risk. Elsewhere we present Ruffer's participation in the CDP Non-Disclosure Campaign, as well as stewardship activities from the fourth quarter of 2021.
Read
2020 Stewardship report
Our 2021 report highlights the depth and breadth of our stewardship activities. Our focus on engaging directly with company management has afforded us a deeper understanding of the companies in which our clients are invested.
Read
Climate Change Framework 2021
Our inaugural TCFD Report introduces Ruffer’s Climate Change Framework and provides a response to the recommendations of the Taskforce for Climate-related Financial Disclosure. The report exhibits our climate-related activities over the past few years and provides an insight into how our understanding of the risks facing our investee companies has evolved.
Read

1  As at December 2021, Ruffer portfolios hold UK, US, Japanese and Brazilian government bonds
2  Morgan Stanley (2021), ESG Fixed Income Investor Survey
3  CarbonBrief (October 2021)
4  FTSE Russell (December 2021)

Past performance is not a guide to future performance. The value of investments and the income derived therefrom can decrease as well as increase and you may not get back the full amount originally invested. Ruffer performance is shown after deduction of all fees and management charges, and on the basis of income being reinvested. The value of overseas investments will be influenced by the rate of exchange.

The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment or financial instrument, including interests in any of Ruffer’s funds. The information contained in the article is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. This document does not take account of any potential investor’s investment objectives, particular needs or financial situation. This document reflects Ruffer’s opinions at the date of publication only, the opinions are subject to change without notice and Ruffer shall bear no responsibility for the opinions offered. Read the full disclaimer.

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London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France