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2020s Vision: ESG investing comes to the debt markets

    Stuart Culverhouse
    Stuart Culverhouse

    Chief Economist & Head of Fixed Income Research

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    Tellimer Research
    17 December 2019
    Published byTellimer Research

    Environmental, social and governance (ESG) investing has been around for years, especially in equities, but it has lagged somewhat in fixed income. However, ESG has gained traction in the past year and, as we discuss in today's 2020s Vision theme, we think this could change the nature of the EM and frontier debt market over the next decade. 

    ESG is gaining prominence among the fixed income community

    Rating agencies are now incorporating ESG factors into the ratings process¹, index providers are introducing ESG-benchmarks², and AUM of ESG-related debt funds is rising, alongside a myriad of new ESG-fund launches, although it is still a relatively small part of the overall investment universe.

    The overall ESG bond market is less than 1% of the US$110tn global bond market, according to the IIF. But there appears significant investor demand for ESG-related products, such as green and blue bonds. Indeed, it might only be a matter of time before we see benchmark international bonds issued in the primary market by EM issuers targeted at ESG investors with specific use of proceeds in mind.

    Focusing on ESG factors, which essentially put more weight on non-financial terms, could have the following benefits:

    • Confer reputational advantages on its followers.
    • Encourage longer-term investment decisions.
    • From a development point of view, it may better align private capital flows with sustainable development goals (SDGs) in emerging markets.
    • In terms of performance, it may enhance returns (or at least, not diminish them) and improve the risk-return profile.

    However, it is not obvious that ESG-related bonds have lowered borrowing costs for the issuer. Borrowers haven’t achieved lower costs through green bonds compared with conventional bonds, according to IMF research, although if anything, within EM fixed income, we’d argue the more fragmented market and lower liquidity could mean that borrowers have to pay up for such issuance. This might change.

    Five challenges for ESG in the bond market:

    1) Measurement, transparency and consistency. By its nature, ESG is a more normative and subjective discipline than traditional financial analysis. Governments, companies, rating agencies, investors and the public, may be assessing ESG in different ways, using different methods and producing different results. We might expect to see some convergence over time, but lack of consistent methodologies and market standards may limit market development, making it harder to incorporate ESG principles into investment processes and to explain them to a wider audience (for example, why country Z is off-limits for one fund but not another).

    2) Impact on capital flows, access to capital and cost of capital. We expect to see more differentiation in capital flows to developing countries based on ESG principles, and investors will be more selective across sovereign and corporate issuers. This should mean a displacement of capital flows from “bad” countries to “good” countries, and lower borrowing costs for the latter. ESG principles should therefore reduce the size of the investable universe (although what is left should represent a more resilient opportunity set). But does this make some “bad” countries that are starved of private capital even more aid-dependent, or force them to turn to other less transparent and more expensive forms of lending? Indeed, in a strict interpretation, ESG could rule out many frontier and EM markets altogether.

    3) Focus on performance. There is little evidence that ESG-investing impacts performance of fixed income funds, according to the IMF. Restrictions implied by ESG principles could reduce diversification and increase volatility, although others may argue the opposite. But if the performance is comparable, maybe EM investors have nothing to lose from ESG-investing, and something to gain.

    4) Do ESG factors affect the sovereign’s probability of default (and loss given default) any more than traditional credit ratings? Some might argue that ESG-friendly countries are less likely to default. But ESG factors might change only slowly over time and there is only a limited track record for this market. And sustainable bonds are not free of default risk. What will be interesting to see over time, for example, is the default experience of green bonds.

    5) Investors may be concerned about an ESG-bandwagon (an investment fad), with products misleadingly labelled green (or sustainable) to tap into this growing market, but without actually being so (so called “greenwashing”). Investors will need to do their own due diligence in order to ensure they are getting what they think they are getting.

    Chart 1: Assets of ESG-listed funds (US$bn)

    Chart 1: Assets of ESG-listed funds (US$bn)

    Source: IMF, GFSR October 2019

    Chart 2: Sustainability-linked bond issuance (US$bn)

    Chart 2: Sustainability-linked bond issuance (US$bn)

    Source: IMF, GFSR October 2019

    Read our full 2020s Vision: 20 themes for the next decade report.

    1. Fitch introduced ESG Relevance Scores for sovereigns in April 2019.

    2. For instance, in the EM universe, JP Morgan launched a new ESG fixed income index (JESG) in April 2018 which adjusts weights for existing EM indices (EMBIGD/GBI-EM/CEMBI) for ESG factors and overweights green bonds.