How ESG Can Enhance Outcomes in Emerging Markets Fixed Income

Stockholm (HedgeNordic) – 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 a way to express their philosophies through portfolio allocations and to potentially generate better investment outcomes. In emerging market fixed income, PineBridge claims, the full integration of ESG analysis into their investment processes has enabled the asset manager 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 (pictured), Head of Emerging Markets Credit Research at PineBridge Investments, discusses some commonly asked questions about ESG investing in this asset class with HedgeNordic and explains how PineBridge seeks to deliver better results through ESG analysis.

Investors and asset managers are increasingly realizing that companies with strong environmental, social, and governance practices can help to mitigate financial risks, and may therefore 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, they can have a measurable material impact on companies’ credit fundamentals and default risk; factors that ultimately impact portfolio outcomes.

Institutional clients who look for strategies that integrate ESG analysis in their investment processes may be motivated by a variety of factors. The desire to measure their 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”, Bates argues.

Bates explains PineBridge ́s approach to ESG in fixed income, stating that “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 emerging market 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 emerging market fixed income strategies we manage. As of July 2020, we have more than 400 companies across emerging markets under active coverage, each with a full suite of ESG data.”

“This level of data gathering is only possible 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,” Bates believes.

An approach based on negative screening is suboptimal in Bates ́ view. “Our focus in ESG analysis is 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,” he explains.

Bates uses an example to highlight the case: “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.”

Bates stresses that PineBridge does not simply walk away from lower-scoring companies. “Our clients normally express their ESG preferences, which guides 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, is a potential opportunity to generate alpha.”

“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, is a potential opportunity to generate alpha.”

Strong evidence now suggests that the addition of an ESG framework does provide an extra layer of protection, especially in periods of market stress. However, 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 emerging market 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.1 In the real world, managing emerging market 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”, Bates observes. “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.”

“Comprehensive ESG scoring does not replace a traditional credit review process, but rather enhances it and helps provide a more forward-looking investment thesis.”

Bates is convinced that ESG is not just another investment style fad. “ESG investing isn’t like “fast fashion, we believe comprehensive ESG analysis will generate alpha over the long term.” The diversity of the investible market in emerging markets demands an active, credit-intensive, and selective approach, he believes. For Bates, this means going beyond relying on predetermined metrics in an index and 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,” Bates recalls and continues “today, we are increasingly called on to illustrate how we use it, provide evidence of the outcomes, and – most importantly – show how we are making an impact through our engagement” efforts with companies. The ESG lens 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. Bates explains that a robust investment process has helped PineBridge to navigate the crisis so far and has deepened what was already a strong focus on ESG-related issues for the firm.

“ESG data for emerging market issuers has become more accessible in step with growing demand for investment vehicles that incorporate ESG, and products to meet this demand have increased.”

“ESG data for emerging market issuers has become more accessible in step with growing demand for investment vehicles that incorporate ESG, and products to meet this demand have increased. We expect these trends to continue if funds that incorporate ESG considerations deliver strong risk-adjusted returns, as we would expect – and as emerging market 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”, Bates concludes.

This article featured in HedgeNordic’s report “ESG in Alternative Investments.”

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About Author

Kamran has been working in the financial industry since 1994 and has specialized on client relations and marketing. Having worked with retail clients in asset management and brokerage the first ten years of his career for major European banks, he joined a CTA / Managed Futures fund with 1,5 Billion USD under management where he was responsible for sales, client relations and operations in the BeNeLux and Nordic countries. Kamran joined a multi-family office managing their own fund of hedgefunds with 400 million USD AuM in 2009. Kamran has worked and lived in Vienna, Frankfurt, Amsterdam and Stockholm. Born in 1974, Kamran today again lives in Vienna, Austria.

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