Apart from a few high-profile credit events, emerging market (EM) corporate debt benefited in 2021 as supportive economic and earnings conditions helped credit spreads grind tighter and deliver positive total returns, despite an increase of US Treasury yields. From a global credit perspective, we still find EM corporate bonds offering attractive value relative to developed market (DM) corporate bonds. But in 2022, selectivity will be paramount. Choosing securities that will outperform will be key in a market where prices, broadly speaking, reflect the supportive fundamental outlook.
We’ve long viewed environmental, social, and governance (ESG) risk considerations as a vital component of active management within the EM corporate bond market and have maintained ESG risk scores on the issuers we cover for more than five years. More recently, though, amid an increasing net-zero push and other initiatives, investors have been bolstering their efforts to manage ESG risks and engage with issuers on meaningful issues of sustainability. The primary objective among investment managers and asset owners is to ensure that their investment capital is used to promote a more sustainable future for the planet and for society. They increasingly understand that mitigating ESG risks can also serve as a valuable tool for downside risk management within portfolios.
And here’s where we see selective risk-taking and ESG considerations converging in 2022: We expect the evaluation of ESG risks to take on a larger role in identifying securities that will outperform in a market where traditional credit risk appears fairly valued.
ESG risks have been factored into corporate credit ratings for some time, so it’s natural to assume that ESG ratings are highly related to credit ratings, with a distribution of stronger-rated ESG issuers among the higher-rated credits within a bond market. Among EM corporate bonds, this notion is seemingly supported by the equivalence of average credit rating and average ESG rating (BBB-) of the JP Morgan CEMBI Broad Diversified index.
But you don’t have to look far to uncover anomalies in this presumptive relationship. At the regional level, the Middle East and Asia are the two highest-rated regions within the JP Morgan CEMBI Broad Diversified index, with average credit ratings of BBB. However, the Middle East and Asia are the lowest-rated regions for ESG within the index, with average MSCI ESG ratings of BB+.
Why the disconnect between credit rating and ESG rating? Given the predominance of energy issuers in the Middle East, the divergence may not be surprising, but those issuers have been equally penalized for a lack of ESG transparency at the governance level for their operations’ carbon intensity. And Asia, the largest market within the EM corporate bond universe, features a large concentration of issuers from China, India, and Indonesia -- all of which have thematic issues that come through in ESG ratings. Chinese corporates tend to score lower on social issues, Indian corporates tend to have weaker governance ratings, and Indonesian commodity issuers tend to have higher environmental risks.
Conversely, the two regions with the lowest credit ratings – Latin America and Sub-Saharan Africa, both BB – are each rated BBB- for ESG. In Latin America, issuers from Brazil, Chile, and Colombia broadly feature some of the strongest environmental and social ratings within the global EM corporate market. Sub-Saharan Africa, the market’s smallest region, benefits at the index level from a high proportion of financial issuers as well as strong governance ratings in its substantial metals and mining sector.
Another reason for the divergence between ESG and credit ratings can be traced to the effect sovereign credit ratings have on corporate credit ratings; rating agencies apply a sovereign rating cap on corporate credit ratings, regardless of stand-alone credit fundamentals. This certainly plays a role in Brazil, but it’s most evident in Turkey, where above-average environmental and social sustainability profiles and historically strong governance factor into a BBB ESG rating for the corporate bond market, while the sovereign’s B rating has translated to an average B corporate credit rating.
Source: JP Morgan, MSCI as of 20 October 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change.
In a market as diverse as global EM corporate credit, it’s difficult to find broad investment themes that have a strong cross-market relationship to performance. In 2021, excluding idiosyncratic risks in China, EM corporates generally delivered stable, albeit moderate, total returns as credit spreads ground tighter in the face of rising US Treasury yields. And during the year, bonds from issuers with higher ESG ratings than their credit rating outperformed those with worse ESG ratings than their credit rating.
Source: JP Morgan, MSCI as of 20 October 2021. Excludes China property sector and securities with idiosyncratic performance greater than 20% or less than -20% for the year. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change. Given that ESG risk analysis is often said to focus on issues of materiality – factors that can have a material impact on a company’s finances and operations – it’s reasonable to expect solid ESG issuers to outperform. But those factors tend to play out over the longer term and often are more geared toward mitigating downside risks than generating near-term outperformance. More likely, in our view, is that the rise of ESG risk considerations among both asset managers and asset owners is fueling demand for higher ESG-rated issuers.
The relationship between an ESG rating gap and performance was stronger for sectors in which ESG risks are elevated. Environmental risks tend to be areas where asset managers and asset owners prioritize impact, so it’s not surprising that within sectors with heightened environmental risks, such as energy and metals & mining, ESG factors can play a more decisive factor in generating demand and total returns during 2022.
Source: JP Morgan, MSCI as of 20 October 2021. Excludes securities with idiosyncratic performance greater than 20% or less than -20% for the year. For illustrative purposes only. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change.
Given the breadth of various risk premia that contribute to market pricing for EM corporate bonds, it can be difficult to quantify ESG risk premium. Given the issues of materiality and greater investor demand, it stands to reason that better ESG credits will pay a lower cost of capital. But what is the proper premium? While the answer may vary case by case, by looking at similarly rated bonds at equivalent points of the curve within a regional subset of an industry, we can observe a clear difference between higher and weaker ESG-rated issuers across several sectors.
Source: JP Morgan, MSCI as of 20 October 2021. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any opinions, projections, estimates, forecasts and forward-looking statements presented herein are valid only as of the date of this presentation and are subject to change.
This is another area where we believe a comprehensive approach to ESG integration can add alpha: by identifying issuers that are committed to improving their operations’ sustainability and, therefore, their ESG risk rating. We expect the link between ESG risk profile and cost of capital to get stronger as more capital tends to flow into ESG-themed investment strategies. By investing in and engaging with issuers that are at an early stage, but are committed to ESG development, we can not only better achieve our sustainable investment objectives but also enhance performance alpha in our portfolios.
At PineBridge for more than five years we have formally assigned and tracked ESG risk scores to all the EM corporate bond issuers we cover. Such analysis has proven to be a valuable component of our risk management across all portfolios, regardless of investment objective. More recently, we began to consider how a forward-thinking approach to ESG risks could not only enhance our understanding of risk but also potentially contribute to alpha generation. So just over one year ago, we began to assign ESG Trends – which reflect the trajectory of ESG risks over the coming 12 months – to all EM corporate issuers we cover. These proprietary metrics are supplemented by third-party ESG analysis and data, and they form a key component of our investment process across all of our strategies. We have also established a formal engagement framework that provides structure to the ESG issues on which we engage with our issuers and also monitors the frequency, quality, and response of such engagement, which form a core input of our ESG metrics. Taken together, we believe these steps and actions taken by issuers, investment managers, and asset owners on ESG will support the kind of selective risk-taking that taps securities likely to outperform.
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
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