Bond Investors Urged to Update Models for Risk That Ratings Miss
(Bloomberg) -- Some bond investors may be facing bigger default risks than their models indicate.
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It’s a concern voiced by a growing number of researchers studying the impact of climate change on bond markets. Their overwhelming conclusion is that credit ratings are currently failing to capture the threat that extreme weather shocks pose to sovereign debt holdings.
“Rating agencies are looking at physical risk,” Evan Kodra, senior director for climate and ESG at the data services unit of Intercontinental Exchange Inc., said in an interview. “But they don’t seem to directly integrate it in their ratings.”
ICE, the Atlanta-based operator of exchanges for financial and commodity markets, says it’s trying to educate investors on the implications of climate risk for international debt markets.
A few asset managers, such as Federated Hermes and Neuberger Berman Group LLC, have spoken openly about the extent to which climate risk has led them to rethink bond exposures. But those relying solely on credit ratings are likely underestimating their loss risks, according to ICE’s research.
It’s an area of concern that’s attracted the attention of researchers at Barclays Plc, the University of Cambridge and the Chinese Academy of Sciences, among others. A study by academics at the University of Oxford found that current ratings methodologies are “mispricing” risk in the global sovereign bond market, a blind spot they say has “potential systemic implications.”
ICE has found that a high climate-risk score is linked to high default risk. In fact, of the seven nations that scored above 3.5 — where zero is the lowest and five the highest risk score — all ended in default at least once between 1995 and 2020. ICE declined to identify specific countries by name.
Issuers in hotter, drier places face “a systematically higher default risk,” Kodra said.
The major credit ratings agencies say they’re aware of the concerns. But they note that many factors go into a sovereign rating and caution against overstating the role climate change plays.
Roberto Sifon Arevalo, global head of sovereign ratings at S&P Global Ratings, says many of the academic conclusions about credit ratings are “oversimplifications of the ratings process.” Natural disasters don’t always impair a country’s ability to pay back its debt, he said in an interview. S&P provides “sovereign credit ratings, not climate ratings.”
“We live in a much more concrete world, and there are plenty of other factors that weigh more heavily in their impact” than climate events, he said.
Moody’s Investors Service didn’t immediately reply to a request for comment. The company has previously said it “systematically, consistently and transparently” incorporates credit-relevant ESG factors, including climate risks, into its ratings. Earlier this year, it said worsening water shortages triggered in part by climate change now pose a risk to India’s sovereign credit strength.
A spokesperson for Fitch Ratings referred to a 2022 report, in which the company said that “no sovereign has yet been downgraded explicitly due to climate change, but it has been a contributory factor to some rating decisions.”
Scope Ratings of Germany says that a disorderly transition — whereby economies aren’t prepared for the fallout of climate change — represents the greatest risk for European countries by 2050, potentially inflating EU sovereign debt burdens by as much as 5% of gross domestic product. It’s identified Italy, Spain, Portugal and Greece as the most exposed EU countries to GDP losses from unmitigated climate change.
“It matters over the long term,” Dennis Shen, senior director at Scope, said in an interview. “If nations do nothing on climate they’re likely to be penalized in their sovereign ratings.”
Researchers at the University of East Anglia and the University of Cambridge estimate that as many as 63 sovereigns “would suffer climate-induced downgrades” greater than one step by the end of the current decade in a scenario that they described as “realistic.” The research, published in December, pointed to a ripple effect that increases “in intensity and across more countries over the century.”
Climate vulnerability also has a “significant negative impact on sovereign ratings, and climate readiness has a significant positive impact on them,” according to a separate study by researchers at the Chinese Academy of Sciences. And an analysis published last year in the financial journal Borsa Istanbul Review showed how climate change is already leaving its mark on default swaps.
“This has implications for the cost of borrowing” and even the ability of some issuers to “access financial markets,” according to the study’s author, Nader Naifar.
ICE, which in its climate research points to the failure of ratings firms to competently identify bond risks ahead of the 2008 financial crisis, notes that the countries most at risk of climate-related downgrades are also some of the most economically vulnerable.
Poorer countries often can’t afford to prepare for climate change, says Phoebe DeVries, product manager at ICE. They’re “already in debt, and upfront investment in climate adaptation comes at a high cost,” she said in an interview.
Mark Bernhofen, a flood risk expert at the Environmental Change Institute at the University of Oxford, says that a number of poorer countries may be facing ratings downgrades within the coming years.
“As the cost of their debt goes up, it becomes harder for them to spend money on adaptation, and their vulnerability gets worse,” he said in an interview. “It’s a vicious spiral.”
In an analysis of flood-prone Thailand, which has a debt-to-GDP ratio of about 60%, Bernhofen’s team showed that flooding may “result in significant capital stock and macroeconomic losses,” creating the “potential for sovereign credit rating downgrades, both today and in the future.”
For now, ratings downgrades have come after the fact when disaster has already hit and investors are scrambling to cover losses. Following the floods that left Pakistan on its knees in 2022, for example, both Moody’s and Fitch downgraded the country’s sovereign rating.
“The countries with the highest level of indebtedness ratios are also the places facing increased climate consequences,” Kodra said. “They have high socio-economic vulnerability and access to capital is more tenuous.”
--With assistance from Shelby Knowles.
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