Debunking ESG myths in Emerging Market Debt

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Investors often discount the importance of environmental, social and governance (ESG) analysis in Emerging Market Debt (EMD) investing, based on perceptions that emerging market governance is inherently weak or that data is lacking.

However, in a recent research paper, Insight Investment’s Emerging Market team argues that these views are misconceptions. ESG analysis has “in our opinion, the potential to generate enhanced alpha for investors and should be a structural component of EMD investing,” they note.

The research reports “ESG analysis has become an important part of credit analysis for developed market corporates, principally as part of investment grade corporate portfolios. When one understands the benefits that can accrue from integrating ESG factors into the investment process, it is not difficult to see why this has become the case.

“ESG analysis can serve to generate early warning signals that potentially enable investors to avoid ‘landmine’ investments and the losses that often ensue. A correctly integrated ESG process can, through mitigating ESG risks, potentially lead to improved risk-adjusted returns and value creation over the long term

“And despite the clear benefits of ESG analysis, its adoption by EMD investors has been lacking.

“Investors mistakenly see ESG and EMD as incompatible, with two misconceptions typically cited.

First, governance standards for emerging market corporates are perceived as being much lower than for their developed market equivalents. Linked to this is the impression that because standards are intrinsically weak across emerging markets, ESG analysis is largely irrelevant because markets will not price in good or bad governance

“Second, ESG analysis is seen as being prohibitively challenging to conduct for emerging market corporates given poor data quality, and lack of availability and disclosure of data.”

The Insight team notes “However, we would argue that these are misconceptions. Comparing similar-sized corporates from the same industry in emerging and developed markets, we find that ESG ratings in some sectors are closer than investors might expect.

“At Insight, we believe the embedded evaluation of ESG risks and opportunities is key to security selection.”

Case study: Telco company

Investors who properly understand ESG have the potential to get rewarded. This telco company reported potentially improper payments made on its behalf. This resulted in bond prices falling 25% as investors worried over the prospect of a substantial fine, a potential loss of its operating license, or bankruptcy. Yet the payments were made on the company’s behalf, not by the company itself. Furthermore, the anomalies were spotted because of the company’s internal controls. Its cash flow and capital were such that it could potentially absorb even an abnormally large fine. Its license had been granted under ‘usufruct’, granting the company free use and transfer of the license indefinitely. Over the course of the next year the market  repriced the risk arising from these ‘potentially improper payments’ appropriately, with the bonds entirely recovering their previous losses.

Read the full report.

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