Throughout the low-interest-rate period and most recently with disruptions related to the coronavirus pandemic, investor interest in environmental, social, and governance (ESG) factors has continued to accelerate, both as way to express their philosophies through portfolio allocations and to potentially generate better investment outcomes. In emerging markets (EM) fixed income, the full integration of ESG analysis into our investment processes has enabled us not only to isolate potential downside risks, but also to spot critical inflection points in a company’s lifecycle – uncovering compelling opportunities in the process.
John Bates, Head of Corporate Research for Emerging Markets Fixed Income, answers some commonly asked questions about ESG investing in this asset class and explains how PineBridge seeks to deliver better results through ESG analysis.
Q: What is the materiality of ESG factors in EM fixed income?
Investors and asset managers are increasingly realizing that companies with strong environmental, social, and governance practices in their businesses pose lower downside financial risks, and thus may perform better over the long run than those with weaker ESG policies. The idea is intuitive: Companies that comply with environmental standards may face fewer operational disruptions and avoid hefty fines. Robust corporate governance practices may mitigate losses from fraud and allow for sounder and more transparent decision-making at the top. Social responsibility is reflected in the quality and safety of a company’s operations and products, and therefore affects demand. So while many ESG practices may appear non-financial in nature, they can have a measurable material impact on companies’ credit fundamentals and default risk, and ultimately on portfolio outcomes.
Q: What is PineBridge’s approach to ESG in fixed income?
Institutional clients who look for strategies that integrate ESG analysis in their investment processes may be motivated by a variety of factors – for example, a desire to measure their own impact on the planet, or to align with specific beliefs. As securities selectors, it’s our responsibility to express our clients’ philosophies or beliefs in the portfolios we manage.
For us, ESG analysis is not a box-ticking exercise, but a dynamic and disciplined process. As active managers, we look at each issuer in the EM universe. We gather data and score issuers according to a number of factors aligned with the UN Principles for Responsible Investment (PRI)-. These scores, together with our analysts’ extensive research of credit fundamentals, are the basis of the team’s decision whether or not to invest. We apply our proprietary scoring system uniformly across all EM fixed income strategies we manage. Today, we have more than 400 companies across EM under active coverage, each with a full suite of ESG data.1
This level of data gathering is possible only with a dedicated analyst team that is constantly engaging with companies – kicking the tires, asking company management teams pointed questions, and recording the outcomes within their ESG scores.
Q: Why do you consider an approach based on “negative screening” as suboptimal?
Our focus in ESG analysis is on risk identification and management. While we do use a weighted scoring matrix that analysts assign to each issuer, that is only one step in our credit selection process. We don’t just buy the highest-ranked issuers and underweight the lowest ranked.
For example, we analyzed one country’s national power company, which has the lowest credit ratings, the highest spread versus its host country’s bonds, and the highest-risk ESG score – all of which makes intuitive sense given that higher risk equals higher spreads. The national gas producer from another country, on the other hand, has a higher credit rating, a comparatively high-risk ESG score, and yet the lowest spread versus its host country’s bonds. Several factors explain this anomaly, and as such, our investment decision goes beyond these scores.
We also do not simply walk away from lower-scoring companies. Our clients normally express their level of ESG tolerance, and we are guided by this input when aligning our positioning. Moreover, we recognize growing indications that engaging with lower-scoring companies to improve on their ESG records – rather than screening out companies based on a point-in-time ESG metric – may improve alpha potential.
Q: Can ESG-linked EM fixed income products offer investors better returns?
Strong evidence now suggests that the addition of an ESG framework does provide an extra layer of protection, especially in periods of market stress, although the generation of stronger returns across all periods of a market cycle is still an open question. The MSCI Emerging Markets Leaders Index, a capitalization-weighted equities index providing exposure to EM companies with high ESG performance relative to their sector peers, has shown similar return performance to an equivalent non-ESG index, albeit with much lower volatility.2 In the real world, managing EM fixed income involves liquidity considerations that may limit an asset manager’s ability to simply switch in and out of weaker investments in a time of crisis. During the Covid-19 pandemic, for instance, we’ve found that companies with the weakest ESG scores performed the worst in the March selloff, but were then the top performers in the second quarter. So the answer, at least for now, is that comprehensive ESG scoring does not replace a traditional credit review process, but rather enhances it and helps provide a more forward-looking investment thesis.
Q: Is ESG investing just another investment style fad? What can investors look forward to in the future?
ESG investing isn’t like “fast fashion” – we believe the growing evidence of alpha potential from ESG analysis will prove durable over the long term.
In our view, the diversity of the investible market in EM demands an active, credit-intensive, and selective approach, and this means going beyond relying on predetermined metrics in an index. Asset managers must engage with company management teams to assess the corporate culture and controlling influences.
It wasn’t long ago that we were often asked only whether we had an ESG framework integrated into our investment process. Today, we are increasingly called on to illustrate how we use it, provide evidence of the outcomes, and – perhaps most importantly – show how we are making an impact through our engagement” efforts with companies. The ESG lens being trained on investment managers has grown increasingly powerful, a trend that will only accelerate amid mounting evidence that companies’ strength in ESG measures can translate into stronger returns.
During the Covid-19 crisis, participants in all areas of investment have faced challenges to varying degrees, from asset owners to asset managers to investee companies and governments. A robust investment process has helped us to navigate the crisis so far and has deepened what was already a strong focus on ESG-related issues.
ESG data for EM issuers has become more accessible in step with growing demand for investment vehicles that incorporate ESG, and products to meet this demand have proliferated We expect these trends to continue if funds that incorporate ESG considerations deliver strong risk-adjusted returns, as we would expect – and as EM debt investors seek not only a more robust approach to managing risk, but also a way to pursue impact investing without missing out on returns.
1As of 20 July 2020.
2Source: J.P. Morgan, Bloomberg Barclays as of 30 June 2020. 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.
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As of 31 March 2020