Sustainability is becoming a critical factor for Asian bond investors
As investing through an environmental, social and governance (ESG) lens continues to gain momentum in Asia, the call for more sustainable bonds is growing.
Morningstar data for 2020 highlights that the lion’s share of ESG assets, at US$25.4bn, were in equity funds at year-end. But sustainable bonds have become increasingly popular – after just one fund launch across Asia in 2019, last year witnessed 12 new vehicles come to market1 . This mirrors global trends, with issuance of sustainable bonds hitting a record volume in 2020 at US$491bn, according to Moody's Investors Service, up from US$323bn a year earlier.2
A clear sign of the increasing appetite in Asia was the order book for the world’s first US dollar-denominated sustainability-linked bond by a real estate developer. Hong Kong-based New World Development’s 10-year, US$200m issue was six times oversubscribed, with nearly 80% allocated to ESG investors.3
The desire for bonds that meet such criteria is a welcome trend. The region is broadly branded for its relatively poor track record on sustainability, due to high levels of carbon emissions, problems with water scarcity, ageing populations and governance issues that stem from the prevalence of family-run businesses.
Yet it is also precisely due to these issues that investors have seen the potential to drive returns while also doing good for the world around them, via fostering change from better disclosure, greater diversity and more board independence.
To achieve this, there is consensus among market practitioners of an urgency to find solutions to common investor concerns such as how to bridge ESG data gaps to smoothen implementation. For example, despite the volume of ESG data, there is a notable lack of a standardised methodology to quantify many of the relevant factors.
As a result, bonds without a proper ESG rating, or those with low ratings, get removed from some portfolios. This creates a situation where certain investment strategies will be more passive and more concentrated after being fully ESG integrated.
Adding to the challenge is the fact that ESG factors are dynamic in nature, defined differently across countries and regions, and suffer from inconsistencies in reporting and disclosure.
Sanctions complicate Chinese companies’ ESG progress
For investors with sustainability issues top of mind, China offers some scope for optimism.
The country’s commitment to confronting pollution and other climate problems will likely see investments into the renewable energy sector soar4 . However, engaging with the larger asset owners such as pension funds and insurance companies can be challenging given the lack of mandatory ESG disclosure requirements for listed companies.
This needs to change in line with Beijing’s promise to bring emissions in the world’s biggest emitter of greenhouse gases to a peak before 2030 – on its path to becoming carbon neutral by 2060.5
Yet recently-introduced US sanctions on companies with ties to the Chinese military (see box below) adds further hurdles to consistency and clarity over the investable landscape.
Among the implications for investors is ambiguity over the extent of the impact on potential trading, and therefore liquidity, in regard to the sanctioned names. As a result, the appetite and ability of market makers to add risk via these names will very likely be affected.
In response to the sanctions, global index provider FTSE Russell, for example, said it would remove eight Chinese companies from several of its global benchmarks. S&P Dow Jones Indices, NASDAQ and MSCI have also responded in similar ways6 .
Meanwhile, JPMorgan, one of the key emerging markets and Asian bond index providers, stated that it will not add any new exposure to sanctioned names in its index composition, but also said existing bonds from those firms will remain in the index, at least for the time being.7
The differences in approach highlight the short-term market uncertainty. Longer term, the full-scale impact of these sanctions will likely only emerge after the 11 November US deadline this year. Yet this might also present opportunities, since some companies with good fundamentals could become cheaper.
US sanctions at-a-glance
- Executive Order – former US President Donald Trump signed this on 11 November 2020 to prohibit US persons from investing in Chinese firms determined to be owned or controlled by the Chinese military, a list containing 35 domestic companies.
- Timeline – taking effect on 11 January 2021, US persons have until 11 November 2021 to divest their holdings in those names, with buy orders banned from 11 January. After the deadline, securities must be held to maturity.
- Subsidiaries – these will be added as restrictions, although the scope for what subsidiaries will be remains unclear. In addition, since November last year, the list of sanctioned companies has grown to include some firms without direct military ties but with varying degrees of Chinese Communist Party affiliation.
Despite lingering questions over certain Chinese names, there’s little doubt that the domestic ESG investment space is going to develop.
Notably, support for the merits of ESG for bond investors is growing within China. A CFA Institute report in conjunction with the United Nations Principles for Responsible Investment in 20198 showed that Chinese finance professionals expect ESG issues to have a more frequent impact on bond yields and spreads by 2022. More specifically, 57% said governance issues will impact corporate bond yields/spread in China by 2022, versus 26% in 2017. For environmental issues, the findings were 48% by 2022 versus 13% in 2017, and for social issues, it was 43% by 2022 versus 17% in 2017.
The ESG value-add
Globally speaking, there is an ever-wider body of research that shows the benefits of ESG integration more broadly. In turn, this is luring return-seeking bond investors and benchmark-focused portfolios alike to create a more prominent role for sustainability amid their investment exposure.
In short, studies have shown that ESG-focused bond funds tend to be more resilient to downside risk, relative to conventional funds. According to research conducted by Fidelity, for instance, which covered the first nine months of 2020, companies with good characteristics have more prudent management and will demonstrate a greater robustness in a crisis.
Supporting these findings, albeit over a short nine-month timescale, the bonds of the 154 companies with an ESG rating of ‘A’ showed a return of around -0.5% on average, compared with -1.5% for the 557 B-rated companies, and -4.6% for the 225 D-rated firms.9
Further, the research suggested the market discriminates between companies based on their attention to sustainability matters, both in crashes and recoveries.
A key outcome, therefore, is justification for sustainability to play a more meaningful role in active portfolio management.