The ESG & Quasi Sovereign Bond Conundrum
By Thede Rüst, lead portfolio manager of Nordea’s Emerging Stars Bond strategy
Quasi sovereigns, bonds issued by fully state-owned companies, account for a substantial slice of the emerging markets (EM) fixed income market.
In fact, three of the five largest EM corporate debt issuers are fully state owned. To many investors, this segment of the market is way to enjoy a level of safety similar to sovereign bonds, but with a higher yield. This is enticing at a time when yields for many sovereigns and investment grade corporates are at record lows.
However, despite fully state-owned companies representing about 20% of our strategy’s benchmark – the J.P. Morgan EMBI Global Diversified – we avoid this area of the market as we believe fully state-owned companies can represent an ESG risk in EM debt.
Fully state-owned companies in EM are often less efficient and frequently run with political objectives threatening commercial goals. Since key management personnel usually gets nominated by the government, incentives for long-term business planning are low. Additionally, the lack of independent oversight makes fully state-owned companies prone to corruption. An IMF study found state-owned companies in countries with a low control of corruption have a significantly lower profitability than private sector counterparts.
Spreads could decouple
In theory, fully state-owned companies enjoy one consolation for all this interference – the state will step in as the lender of last resort. This supposition of government backing is a key reason why fully state-owned companies are included in several emerging market sovereign debt benchmark indices. Ratings agencies subscribe to this view and give ratings based on this assumption. There is rarely an explicit guarantee, but rating agencies see it as an implicit one.
To many investors, bonds of fully state-owned companies are therefore satellite bonds orbiting round sovereigns – which explains why pricing often moves in line with sovereigns. On aggregate, yields on bonds of fully state-owned companies fell in 2020 in harmony with sovereign debt. Indeed, cases of debt restructurings for fully state-owned companies are rare. However, for an increasing amount of fully state-owned companies, investors could start questioning the ability and/or the willingness of the sole shareholder to support the company. This may decouple spreads for individual issuers from the respective government bonds in the future.
Increasing leverage on sovereign balance sheets might amplify this development. We already see cases of this, as evidenced by the widening spreads between individual state-owned company bonds and the respective government debt. Higher funding costs, as well as a global push to redirect capital towards business models supporting the UN’s SDGs, might make refinancing more difficult for many of those issuers.
Another crucial reason why we currently do not invest in fully state-owned companies is the fact many have low levels of non-financial disclosure. Because of a lack of information, most companies do not have ESG ratings from third party rating providers, such as MSCI. According to our analysis, more than 70% of index-eligible fully state-owned enterprises do not have a corporate-level rating – or hold a very low B-rating, or below.
Exciting EMD innovation
Even though we avoid quasi sovereigns, it is an exciting time to be an ESG-focused investor in EM corporate debt. Since the beginning of 2020, we have been complementing our ESG-focused EM sovereign bond portfolio in Nordea’s Emerging Stars Bond strategy with the addition of corporate bonds.
Financials make up the largest sector among privately-owned corporates, accounting for 30% of the EM corporate bonds benchmark index. While we place the same ESG demands on financials as we do on non-financial corporates, we also have strong preference for signatories of the Principles for Responsible Banking – of which Nordea is a founding signatory. The business strategy of these banks must align with the SDGs, the Paris Climate Agreement and relevant national and regional frameworks. Banks in this category include Mexico’s BBVA Bancomer and Colombia’s Bancolombia.
We are also enthusiastic about recent developments in ESG-related bond issuances. While green, social and sustainable bond issuance has grown rapidly in recent years, we recently saw the first issuance of a sustainability-linked bond from an EM issuer. Brazil’s Suzano, the world’s largest pulp and paper producer, issued a bond in September linking the coupon rate to greenhouse gas emission targets. It has paid off for Suzano, with the bond trading with a lower spread than its conventional bonds.
We are also interested in the involvement of multilateral development banks in new bond issuances. Instead of rolling over existing loans or providing new loans to issuers, the entities are co-investors with private sector asset managers. We welcome this development, as it gives issuers previously reliant on development financing access to private capital and bond investors can obtain exposure to companies not previously present in the bond market. An example is Georgia Global Utilities, which issued its inaugural bond in July of 2020. Investors in the $250m bond, the first green bond issued out of Georgia, included Deutsche Investitions und Entwicklungsgesellschaft mbH, the Netherlands Development Finance Company and the Asian Development Bank.