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Implementing an ESG framework in EM fixed income investments

Jens Nystedt
Jens Nystedt
Investment Team
Oliver Faltin-Trager
Investment Team
Kyle Cornfield
Investor Relations
31 August 2019

Emso Asset Management has had an ESG Policy in place since 2014 and has been a signatory of the Principles for Responsible Investment (PRI) since 2015. Our approach to environmental, social, and governance (ESG) factors has evolved over the ensuing years as we have worked to devise a robust and substantive approach to ESG investing in the emerging markets fixed income space. We explore below why ESG is becoming such a prevalent factor in investment decisions for end-investors, how Emso is increasingly integrating ESG factors into its investment process, and the potential overall impact of implementing an ESG overlay could have on valuations and yields. Lastly, we explore ideas on how, by focusing on ESG score trends, i.e., improving stories, rather than absolute scores, ESG investing within an emerging markets fixed income strategy could have a catalytic role.

While incorporating ESG factors into investment decisions is increasingly commonplace among equity investors, it has yet to become part of mainstream fixed income investing, particularly for investments in sovereign and quasi sovereign issuers. We believe a lack of a consistent source of data at the sovereign level and the fact that fixed income investors typically have less influence than equity investors on a company’s management result in the need for a different approach to the integration of ESG into EM fixed income portfolios. The impact that investors can have on a sovereign is also quite limited unless ESG factors become a dominant driver of investment flows. Nevertheless, the importance of considering ESG factors in order to mitigate some of the global challenges we face, including climate change, hunger and poverty, corruption, and the need for empowerment through gender diversity and reduced inequalities, is becoming increasingly apparent. Many end-investors are therefore looking for sustainable policies, for both equities and fixed income investing, at both a macro and company level, to ensure that their resources are invested in sovereigns, quasi-sovereigns, and corporates, that meet a minimum ESG threshold. However, currently no accepted standard of ESG investing exists with regard to fixed income in general or EM in particular. We are committed to developing productive and flexible approaches to the integration of ESG into our investment processes and mandates for both traditional and absolute return portfolios.

Governance factors have long informed Emso’s investment research and remain the dominant ESG factor for most of our investment universe. Over the last year, we have also incorporated environmental and social factors into our investment analyses and fair value models using third party data providers. Our preliminary observation is that ESG factors play a statistically significant role in our models, enhancing their explanatory power, but the specific factors, and the impact of those factors, vary across countries and issuers over time. Our research indicates that ESG factors are also gradually increasing in importance within the EM sovereign investment space. Rather than simply applying ESG data as an exclusionary overlay, we integrate the data into our investment process via an econometric modeling framework that we believe allows us to improve investment outcomes. This process, which analyzes the relevant political, legal, technical, and economic risk factors of an investment opportunity, then feeds into our econometric modeling framework. Moreover, we believe that using an empirical approach to integrate granular ESG data inputs has improved model accuracy across a broad set of our medium-term fair value models, thereby improving our investment process and ultimately, we hope, our investment outcomes.

Our research suggests that when comparing various asset classes, ESG factors play the biggest role in explaining the fair value in sovereign credit spreads as illustrated in the table below. Depending on the country, we find that ESG can also add explanatory power to EMFX models as well as local interest rates. On average, our research suggests that ESG inputs provide the most significant improvement to the accuracy of our fair value models in sovereign credit, followed by local rates, and finally EMFX.

Country ESG table

Source: Emso based on Verisk Maplecroft data, April 30, 2019. Note: The values in this table are derived from a recent version of our fair value models. We construct one fair value model for each sovereign credit spread and this table provides the percent of models within an asset class (e.g. percentage of countries) for which the ESG data is incorporated in the model as a result of having a statistically significant relationship with the value of the sovereign credit spread. The opposite sign percentage indicates the percentage of models where the sign of the relationship is counterintuitive (e.g. higher ESG risk implying a tighter sovereign credit spread). We also construct one version of each model with the ESG score included as a single model input (“all-in-one”) and one version where the E, S and G scores are included as separate inputs.

Where there is a significant correlation between ESG factors and a country or asset, we find that the sign of the relationship is sometimes counterintuitive, particularly for environmental factors. As studies have noted 1, it is commonplace for environmental factors to be either ignored or lead to counterintuitive results. However, on further reflection, as these models measure how markets are pricing in ESG factors rather than how they should be pricing them, a higher environmental score is often inconsistent with boosting commodity production and exports. For example, in our sovereign spread models, Peru, Brazil, and Chile have the highest negative sensitivity to higher environmental scores. Hence, the better these countries do on their environmental score, the higher their perceived sovereign risk premium as reflected in the CDS spread the market would require. We presume this is because more environmentally friendly commodity extraction is significantly more costly in the short term, which reduces the US dollar revenues for the government and in turn, reduces the country’s capacity to repay sovereign bond holders. As ESG investing matures, it will be interesting to see whether the market can turn the sign of these coefficients around such that countries, or even commodity exporters, will see an improvement in their risk premia as their adherence and adaptation of environmental factors improve. We have found that adding ESG factors to fair value models yields interesting results. The chart below shows the richness and cheapness implied by our fair value models before and after incorporating ESG factors. Where the ESG data has no impact, the points lie on the 45-degree line. Incorporating ESG, however, shifts the spread for a handful of sovereigns from having been flagged initially as “cheap” to now being “rich” (e.g., Chile). Incorporating ESG factors currently has the largest impact on Turkey and Thailand CDS fair values, which look cheaper after taking into account ESG factors. In Turkey, this is partially the result of the models loading on ESG scores instead of other fundamental inputs, which may be more volatile when a sharp idiosyncratic sell-off occurs.

Fair value sovereign CDS model with and without ESG factors CDS Chart

There has been a long-running debate on whether investment decisions based on an ESG focus or overlay would dampen overall returns of a portfolio or lead to unwanted concentration risks. We believe that this is primarily because ESG-focused portfolios are less likely to be invested in some of the highest yielding opportunities, especially in the frontier markets. Since higher quality EM issuers typically have better developed yield curves with longer maturities, this leads to higher concentration and higher duration in exchange for improving a portfolio’s overall ESG score. Unless the concentration risk is actively mitigated, ESG overlays in EM fixed income will, in our experience, likely reduce running yields and reduce diversification.

An important step forward in highlighting the gradual development of implementing ESG factors in EM fixed income investments was JP Morgan’s decision in March 2018 to launch the JP Morgan ESG Index (JESG) with the goal of integrating ESG factors into indices offering a similar risk-return profile to that of the parent benchmarks. The original JP Morgan EMBI Global Diversified Index, which tracks hard currency debt, the JP Morgan GBI-EM Global Diversified Index, which tracks local currency debt, and the JP Morgan CEMBI Broad Diversified Index, which tracks external corporate debt, have long been the standard by which asset managers in the emerging market fixed income space are benchmarked. The launch of the JESG indices, which integrates ESG factors into each of their long-standing composite benchmarks, also offers a framework to assess both the costs associated with an ESG overlay on a portfolio and a benchmark by which investors can compare different approaches.

The JESG indices exclude issuers with weak ESG scores, which are also typically associated with higher risk premia. We believe, however, that including emerging market countries on an improving ESG path early in the investment process can have a ‘catalytic’ approach to investing. In emerging markets fixed income, a key source of potential alpha is in investing in countries considered “out-of-favor”. A positive ESG catalyst in a low-scoring issuer can be seen as an indicator that the issuer may potentially be turning a corner. Given that ESG scores react much more slowly than market pricing, exclusionary methods implemented when incorporating ESG factors into the investment process often forgo the potential catalytic opportunities that exist early in an issuer’s transition from being considered ineligible to eligible for investment. We would argue that by applying Emso’s fundamental research process, consisting of both qualitative and quantitative frameworks, issuers could be identified as “improving stories” from an ESG perspective and should therefore be eligible as part of the investment universe, even if they do not meet a certain ESG minimum threshold yet. Such an approach would allow a portfolio to get early exposure to improving ESG stories before the actual ESG scores “catch up.” We would argue that carving out a part of any ESG mandate for improving stories would go some way to counteract the effects on running yield and portfolio concentrations that may otherwise affect a pure ESG exclusionary overlay.

In conclusion, incorporating ESG factors into our investment process has already enhanced our fair value models across asset classes, and the significance of ESG factors is likely to increase over time. JP Morgan’s new JESG benchmarks represent a game changer for the maturation and standardization of using ESG measures in EM fixed income investment as the MSCI ESG indices do for equities. However, we believe that applying a JP Morgan-based exclusionary ESG overlay comes at a cost and that allowing for an “improving stories” or a catalytic approach could mitigate these costs. We think the catalytic approach will enhance flexibility (relative to an exclusionary approach), leverage our existing research process, and be beneficial for end-investors as they get earlier exposure to a theme that could generate significant total returns as an issuer improves its ESG score.

  1. 1 “The role of ESG factors in sovereign debt investing” by BlueBay Asset Management and Verisk Maplecroft, 2019.

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31 July 2019
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Patrick Esteruelas
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