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Selecting for alpha in emerging markets debt

02 August 2019

3 minute read

By Damian Payiatakis, Head of Impact Investing

Non-financial data can be vital to spotting yield opportunities in emerging markets corporate debt and improving portfolio performance.

In this late-cycle environment, with investors struggling to generate income, as a house we believe that emerging markets debt (EMD) can offer attractive yield opportunities. That said, selection is key.

Generating alpha through security selection can be challenging. But in EMD, where higher levels of information inefficiency exist more than in many other asset classes, it is tougher still. Investors who incorporate non-financial data into their decisions can gain an information advantage to identify the best risk-reward opportunities in the asset class.

Below we outline why and how inclusion of non-financial information in the EMD investment process can improve performance for investors who make the effort.

Appreciating downside risks in EMD

Investors in all corporate bonds are subject to asymmetrical risk – where downside risks of distress or default tend to be larger than the upside produced by returns on committed coupon payments.

Emerging markets have heightened risks given the greater potential for political and economic volatility. Flows of capital in and out of this asset class are primarily driven by currency movements and often a poor understanding of individual market dynamics.

We believe that effective selection of EMD securities requires greater insight into individual issuers. Financial data from accounting statements provides a critical baseline of information. But a more holistic, and informed, approach also includes non-financial information.

Investors who use non-financial information, which is generally split into three categories of environmental, social and governance (ESG) information, can, as we previously explained, better understand an organisation’s long-term risk and return prospects.

Research supports positive impact of using ESG data

A growing body of academic and industry evidence suggests that incorporating ESG considerations into fixed income portfolios is likely to improve returns.

The Quantitative Research team in Barclays Investment Bank conducted innovative research in October 2016, and expanded it in October 2018, that concluded accounting for ESG characteristics can improve bond performance. The team found that investment grade bond portfolios constructed with an ESG tilt, irrespective of data provider, outperformed the market.

Other research1 supports the above findings – that ESG complements traditional factors in fixed income well; and tilts can improve default risk in portfolios.

Notably, most research has focused on the relationship of ESG insight and developed markets and investment grade issuers, where more data is available. However, it seems reasonable to infer a similar correlation between ESG in EMD investing.

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Start with governance, extend to social and environmental factors

Using non-financial data when assessing fixed income is primarily a tool to manage downside risks, though innovative approaches are emerging for upside benefits too.

While governance has generally been the main focus, evaluation of environmental and social risks is increasingly being used in credit analysis, given the new, valuable, insight these factors can provide.

In emerging markets, issuers frequently are private companies and have complex and opaque ownership practices. Starting by reviewing governance continues to be a wise practice to understand the motivations of the issuer. While complex structures may appear unclear, ultimately the aim is to confirm that the interests of the issuer are aligned with long-term debt holders. This can be achieved with insight from non-financial data about governance arrangements, such as board dynamics, director effectiveness, or family commitment to the company.

Improving ESG data in emerging markets

More recently, additional data about social and environmental factors is helping to manage the associated risks and disparities of operating in emerging markets. Regulation in emerging markets is often less stringent and social needs are often higher. This makes controversial behaviour by debt issuers a greater risk, and therefore a likely impact for debt holders.

Although there are a range of ESG risks that could affect an issuer, the materiality of these depends upon the sector and the industry. Disclosure on ESG will help determine the sustainability risks on the business model over the long term.

For instance, in the mining sector social issues, such as health and safety practices, employee relations and community engagement, can materially affect creditworthiness.

Recent disasters in the mining sector in Brazil also point to the importance of environmental issues. For example, the collapse of Vale’s Brumadinho dam in January resulted in at least 60 fatalities, with more than 200 people still missing. While only accounting for 2% of the company’s output, Moody’s cut their rating to Ba1 (or “junk" rating) from Baa3, and S&P Global Ratings and Fitch both cut Vale to BBB-, their lowest investment-grade rating. Investors who missed this risk have been affected accordingly.

Acknowledging data challenges

Transparency and non-financial data remain more limited in emerging markets.

Specialist ESG data providers cover a limited portion of the universe. Private companies who dominate much of the issuance do not have the same, or sometimes any, reporting requirements about their ESG activities. Some investors engage directly with companies to get this insight – and encourage greater reporting.

But transparency is improving. An increasing number of companies are self-reporting as they recognise the benefit to potential investors. Since 2010, 15 key emerging market countries or exchanges have set out regulations for stewardship and governance codes2. Having to publish sustainability reports will offer investors more insights into the company’s management of these non-financial practices.

Value of ESG in security selection

Given the nuances of investing in emerging markets, incorporating non-financial data into investment decision-making can strengthen identification of future risks and opportunities that could affect an issuers ability to repay debt.

This is especially critical when investing late in the cycle. Significant downturns in markets affect all assets, but generally disproportionately more so for EMD and idiosyncratically between EMD issuers. Investors who can look beyond the index, and effectively select assets, stand to generate attractive yield opportunities from this asset class.

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Market Perspectives August 2019

Find out our latest key investment themes. As expectations of more dovish central bank policy grow and early signs of a potential thaw in trade tensions, sentiment has turned for the better. However, with many geopolitical issues on the horizon and several financial markets close to record highs, is it time to de-risk portfolios?

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