Building a Portfolio

Bringing ESG to Emerging Market Debt

BRICS emerging markets trends
December 6, 2018

Since its initial appearance in the late 1980s, the emerging market debt (EMD) landscape has experienced a number of significant developments, including the establishment of Brady bonds, economic crises in Latin America and Russia, and the shift from US dollars to local currencies. One additional new development is the introduction of environmental, social, and environmental (ESG) criteria to emerging market debt investing.

ESG emerging market debt has begun earning the attention of some of the biggest players in investing. According to BlackRock, ESG considerations have the potential to be a “critical input” for investors evaluating opportunities in developing countries.

Bringing ESG Factors into EMD

In a research paper published earlier this year, BlackRock outlines some of the risks more prevalent in emerging markets than in developed economies, including weaker shareholder protections, higher rates of debt default, more relaxed environmental standards, and more political corruption. These are risks that BlackRock suggests an ESG lens can help detect.

Echoing this point in the more specific context of EMD, “Debunking the ESG Myths in Emerging Market Debt,” a paper by asset management firm Insight Investment, argues that “a correctly integrated ESG process can, through mitigating ESG risks, potentially lead to improved risk-adjusted returns and value creation over the long term.” Yet according to the paper, while ESG analysis has come to play a role in developed market credit analysis, it has been slower to come to EMD opportunities. Why? The paper ties this gap to two primary misconceptions: first, that emerging market governance is “inherently weak,” and, second, that there’s not enough data.

To dispel the former perception, the paper reports that Insight’s analysis has found some similarly sized companies in the same industries to have comparable ESG scores, whether they’re in emerging or developed markets. For example, emerging markets technology, media, and telecommunications (TMT) companies were roughly as likely to earn Insight’s lowest ESG rating as US TMT investment-grade and high-yield bond issuers—and emerging markets oil and gas companies were actually less likely to score poorly than their US counterparts. For Insight, this means that doubts about governance standards in developing markets don’t justify eschewing ESG considerations in EMD.

When it comes to data, Insight tasks investors themselves with doing “their own ESG legwork” instead of relying on third parties who may not have comprehensive data. It also suggests that “engaging directly” in dialogue with companies is a key way to “properly evaluate potential ESG risks and mitigants.” BlackRock notes, too, that data is becoming more widely available, with South Africa now boasting standardized ESG reporting.

Insight considers the work required to overcome the potential obstacles to ESG emerging market debt investing to be worthwhile, since “by considering the materiality of ESG risks, investors can generate the potential for enhanced alpha and aim to better manage risks overall,” as the paper states.

ESG Emerging Market Debt in Action

Making it somewhat easier for investors to approach ESG emerging market debt investing, in August BlackRock launched a suite of four ESG EMD funds: the BGF ESG Emerging Markets Bond Fund, the BGF ESG Emerging Markets Local Currency Bond Fund, the BGF ESG Emerging Markets Corporate Bond Fund, and the BGF ESG Emerging Markets Blended Bond Fund. The extent of the offering—spanning US-denominated, local currency, and corporate emerging debt—aligns with the show of confidence in ESG impact investing BlackRock has recently expressed.

“These funds further demonstrate BlackRock’s commitment to innovative, sustainable investment solutions, combining the best of BlackRock’s investing capabilities with insights about how ESG factors can affect long-term, risk-adjusted return,” said Brian Deese, head of sustainable investing at BlackRock. “We are building tools that allow our portfolio managers to analyze relevant sustainability information alongside the traditional financial metrics to inform active investment decisions about where to invest.”

The forerunner to the launch of the new funds was a collaboration with investment firm J.P. Morgan, which saw the duo establish a suite of ESG emerging market debt indices. The indices were created to act as a benchmark for investors interested in incorporating ESG emerging market debt into their investment strategies and will now be the standard by which the new funds are judged. Issuers deriving any revenues from weapons, thermal coal, or tobacco are excluded from the new indices; meanwhile, green bonds receive an outsized index weighting.

“Responsible investing is becoming the cornerstone of many of our clients’ strategies, and having access to a proper global fixed income benchmark that integrates ESG is essential,” said Gloria Kim, head of the Global Index Research Group at J.P. Morgan.

BlackRock isn’t the first asset manager to consider ESG factors in EMD offerings. Neuberger Berman, for example, started to do so some years ago. However, just as with its noteworthy letter to CEOs earlier this year, BlackRock’s size and influence could make waves and prompt some of its peers into action.

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