Why should ESG investors consider EM debt?

We believe emerging markets (EM) present an excellent opportunity for investors to drive change, while participating in an asset class with strong investment potential. EM countries represent the majority of the world’s population and the world’s carbon emissions, meaning there is a huge potential benefit to working toward ESG goals. Aside from the broader merits of ESG investing, we have found that EM debt investors do not have to sacrifice returns to achieve ESG goals. In many cases, we have found that considering ESG factors can positively impact longerterm investment outcomes. 

Focusing on EM might seem counterintuitive to many ESG investors. Compared to developed markets, EM countries tend to have inferior corruption and transparency scores, weaker institutions, greater social inequality, and often produce and export commodities with negative environmental impacts. But it is for these reasons that we believe ESG-oriented investing in EM debt affords a greater opportunity for investors to support and drive positive change compared to developed markets. While many EM countries depend on underdeveloped energy infrastructure, for example, they also have some of the world’s best resources for renewable energy. The use of onshore wind power in Brazil and solar power in India and Africa highlight opportunities to democratize energy in an environmentally sustainable way for growing populations. 

Compared to developed market issuers, EM issuers lag in the availability of sustainability and governance metrics. However, EM sovereign and corporate issuers have good reasons to care about ESG goals and ESG-related investing, and, therefore, going forward, we expect EM engagement on ESG issues to grow. At the sovereign level, ESG investment can reduce the cost of capital for countries that demonstrate improved transparency. Corporate bond issuers are likely to increasingly engage with investors since debt is often a more important part of EM companies’ capital structures and engagement can broaden their investor bases and potentially lower their cost of capital. We have seen evidence of this in the rise of sustainability-linked bonds (SLBs) issued by EM companies (Figure 1) and their lower bond spreads versus sector peers (Figure 2). While the EM corporate asset class was not the first to issue SLBs, it has adopted the structure as its own. Since September 2020, about a third of all SLBs issued globally have been EM corporate bonds.

Impact on investment performance 

We have found that issuers that operate in a more sustainable manner and actively engage with investors on ESG topics are often better managed with business models more aligned with our long-term investment focus. Empirically, this has increased the likelihood of positive investment outcomes and mitigated the likelihood of negative surprises, which are often related to ESG deficiencies. Ultimately, we have found that taking ESG considerations into account in investment decisions has not detracted from performance and has at times enhanced it (Figure 3). 

Adding to the fundamental merits of considering ESG factors in investment decisions are market technicals. Demand for EM assets has grown rapidly since the global financial crisis, driven in part by demand for yield from global investors facing a low yield environment. ESG has also grown up during this period but ESG issuance in EM is still in its infancy, representing less than one percent of outstanding bonds. This is changing rapidly. We expect the net financial effect of the ESG groundswell to be an increased investment opportunity set and a substantial increase in demand, much of which will likely be directed toward EM.

Invesco Fixed Income’s approach to ESG investing in EM credit 

One of Invesco Fixed Income’s core principles is that taking ESG factors into account is part of the robust investment analysis essential to driving good longterm outcomes in the EM space. As such, ESG analysis has been integrated into our investment process for some time. As our clients’ needs have evolved, we have formalized this part of the process. Our analysts and economists now assign standardized proprietary ESG ratings to issuers under their coverage. Our sector research teams establish core ESG risks for each sector to guide consistent research globally and we evaluate issuers’ ESG trajectories and their performance relative to peers. The trajectory is important in EM, since, while absolute ratings often lag developed market peers, the rate of change is often greater. In our view, this rate of change can be as important as the ESG rating itself, depending on client preferences. To prevent “greenwashing”, we use a scoring framework to evaluate ESGoriented bonds, such as SLBs. From a portfolio perspective, we seek to construct strategies with well-defined parameters that enable us to meet our client’s investments objectives in a manner consistent with their values. 

Conclusion 

In our view, the demand for ESGoriented investment strategies is a positive and durable change to the investment landscape. For ESG-oriented investors, we believe EM debt warrants consideration. We believe the asset class offers the opportunity to generate attractive returns while adhering to ESG principles. In addition, the space is made compelling by the significant potential for investors to drive positive change through their investment decisions. This is an important consideration for ESGoriented investors, especially considering the increasingly important position that EM holds in the world economy and society.