Insight 29.07.2021

What ESG factors mean for bonds in EM

The creditworthiness of an emerging market country is often thought to be determined simply by its ability to service and repay debt.

This can be assessed by looking closely at macroeconomic indicators, such as the ratio of debt to gross domestic product (GDP) and GDP growth to assess an economy’s resilience to shocks and its ability to generate revenue, or the current account balance, as a measure of its external vulnerabilities.

In addition to these financial variables that determine its ability to pay, rigorous investors have long included a country’s “willingness to pay” in their assessment of its creditworthiness.

This includes looking at “softer” criteria, such as governance and political stability, the strength of institutions and of the legal environment, the rule of law and the control of corruption.

At UBP, we believe that these “soft” factors should now be extended beyond what traditionally would be considered indicators of governance to encompass social and environmental aspects as well. Indeed, these also constitute future strengths or vulnerabilities that could weigh on a country’s ability and willingness to pay. For example, a focus on health and education can promise faster and more inclusive economic growth, while ignoring the risks of climate change may result in unanticipated budget spending being needed to carry out necessary rebuilding work.

Considering the full extent of environmental, social and governance (ESG) factors is therefore important. This needs to be done with caution, however, to avoid some biases inherent in traditional ESG indicators, which tend to be backward-looking and unnecessarily penalise poorer nations. To mitigate this, we take into account the effort that countries make to improve their practices (momentum) as well as their level of wealth. We also complement signals from our ESG model with analyst sentiment scores to capture the latest faster-moving, material changes. Without such adjustments, many of the world’s poorer nations, which are those that need access to capital the most to finance their development, would be automatically excluded from our investment universe.

“At UBP, the Emerging Market Fixed Income team defines sovereign sustainability as an enduring improvement in institutions and policymaking, which leads to good, long-term management of natural resources, improvements in social outcomes for citizens, and sustainable returns for investors.”

Thomas Christiansen, Head of EM Sovereign Debt

One such case in point is Côte d’Ivoire. Looked at statistically, the country’s ESG score is quite low. However, Côte d’Ivoire is a poor country making significant changes, once we adjust for wealth and momentum, which makes the case for its government bonds a bit stronger.

There is reason to believe that the country’s reconstruction efforts after the civil war of 2010–2011 are having a positive impact on its economic growth prospects. More recently, amongst other issues, Ivorians are taking positive steps to curb child labour, which is reflected in successive upgrades to our ESG sentiment score. Successive post-civil war administrations have started taking account of environmental health and sound natural resource governance, aimed at sustainable development and conflict prevention. The allocation of large parts of the national budget to the critically important sectors of health and education has also been supportive of better social outcomes. Reflecting this, there has been a significant rise in life expectancy, even though, at 57 years, it is still very low by West African standards.

What sets sovereign bonds apart from corporate bonds?

In comparison to corporates, engagement is less well established and also more difficult to measure on the sovereign side. Generally speaking, corporates tend to be less politically motivated than national governments, which is why 100% state-owned corporations have, in certain ways, more in common with national governments than with their privately owned corporate peers. Indeed, their motivations and objectives can be blurred by political influences. Furthermore, on the corporate side, there’s a greater ability to influence management through direct engagement or formal channels, such as voting rights. Ultimately, company boards must answer to shareholders and bondholders, which is not the case for governments which ultimately answer to their constituents.

That being said, there are ways to engage with governments that issue sovereign bonds. Over the past few years, we have witnessed the growing influence of investor advocacy groups. For instance, as members of the Emerging Markets Investor Alliance’s Labelled Bonds Working Group, UBP has made technical suggestions that are helping to codify the emerging Sustainably Linked Bonds market. In turn, this creates a direct financial incentive for issuers to meet specific ESG targets.

Conclusion

It is fair to say that the growth in sustainable emerging market bonds has enhanced the transparency of many governments. Direct financing of sustainable projects through development finance and green and social bonds entails better reporting standards and provides an effective channel through which investors can engage. This creates a virtuous circle, as growing investor interest in the impact of ESG issues in emerging markets fuels demand for sustainable investments.

At UBP, we are convinced that ESG indicators have proven to be an important aspect of sovereign creditworthiness, and we think that this framework can contribute to identifying emerging trends, thus helping investors capture sustainable investment returns and mitigate certain risks in their portfolios.

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Thomas Christiansen
Head of Sovereign and Frontier Debt
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