Emerging market bonds with a focus on sustainability

More and more equity investors are rating companies on the basis of ESG¹ criteria. However, ESG analysis has long since begun making inroads into bond markets² as well. That non-financial factors can have a lasting impact on success is no longer a myth.

In many cases, academic research has concluded that there is a positive correlation between ESG metrics and capital costs.³ Widely accepted ESG methodologies such as those of J.P. Morgan for bond indices lead the way in this area.

Those not wishing to forgo returns in the current market environment of rising interest rates, default risks due to debt restructuring, and geopolitical risks – and who are willing to take an appropriate degree of risk – may consider a sensible addition to their portfolio in the form of sustainable emerging market bonds.

Active emerging market bond funds rarely outperform the benchmark

Despite rising inflation, emerging economies still have a positive real interest rate. In addition, emerging markets generally show higher growth than developed markets and offer a high degree of diversification. Many emerging economies have much lower debt, while their current account is in better shape than a few years ago. The current high level of energy and raw-material prices is having a positive impact on energy and commodity exporting countries. In addition, emerging markets have corrected to a greater extent than their developed peers.

Emerging market debt is often seen as an "inefficient" or "complicated" asset class when it comes to replication, and to that extent they tend to be seen as the preserve of active managers. However, a glance at the S&P SPIVA Scorecard (S&P Indices versus Active) shows the following for emerging market bonds in hard currencies: Over a five-year period, 85%⁴ of active emerging market funds underperformed their benchmark. Although some active managers succeed in beating their benchmark, long-term consistency is very difficult to achieve. In other words: If it is not possible to select the 15% of funds that beat the benchmark, it is better to use the services of an index manager.

J.P. Morgan ESG EMBI Global Diversified Index

The J.P. Morgan ESG EMBI Global Diversified Index (JESG EMBIG) tracks liquid fixed and floating-rate US-dollar bonds issued by emerging-market government and semi-private companies. It is based on the established flagship J.P. Morgan EMBI Global Diversified Index.

The ESG index is based on a methodology for exclusions and weight redistribution (see text box: J.P. Morgan ESG methodology). The index structure consists of three steps: Controversial sectors and business practices are consistently excluded.

This includes issuers who violate the principles of the UN Global Compact, as well as issuers with income from tobacco, thermal coal power, and weapons. Using an ESG scoring system, the 80% of issuers with the highest ESG rating are included in the ESG index. The worst 20% of issuers are excluded. Finally, the weights are adjusted in accordance with the ESG ranking. The highest-rated 20% are weighted at 100% of the base market capitalization, the next 20% at 80%, the next 20% at 60%, and the last 20% at 40%. Green bonds are automatically assigned to a higher level.

Demand for investments in ecological, social, and governance criteria (ESG) has continued to grow in recent years. Our investment ideas with ESG integration provide clues as to where we identify positive long-term risk/return ratios in asset management with ESG investments.

Credit Suisse now offers a suitable investment solution for institutional investors who are thinking about adding the emerging markets theme and wish to use an ESG filter at the same time. CSIF (CH) Bond Government Emerging Markets USD ESG Blue was launched on September 12, 2022, and replicates the J.P. Morgan ESG EMBI Global Diversified Index.

J.P. Morgan ESG's methodology, on which the index is based, results on the one hand in a low tracking error compared with the standard index and on the other in a reduction in risk from a long-term perspective.

Sustainable emerging market bonds outperform the standard index

What return can an investor expect in the long term? A look at the chart and table shows that the long-term performance of the sustainable counterpart compared with the J.P. Morgan EMBI Global Diversified Index over the last five years is 28 basis points more favorable. In addition, the JESG EMBI Global Diversified has a slightly superior average rating of Baa2/BBB+/BBB (vs. Ba1/BBB–/BB+). The ESG Index also scores highly on account of a slightly longer duration of 7.35 (vs. 6.95).

Table 2 shows the top ten countries with the highest weighting in the ESG index. The countries that outperform as part of the J.P. Morgan ESG methodology are weighted higher than in the standard index, for example the United Arab Emirates and Panama. Countries such as Nigeria, Angola, and Iraq are excluded completely (see Table 3). Compared with the standard index, therefore, 60 countries are still included in the ESG index and it has only 236 issuers fewer (standard index: 935 vs. ESG index: 699). This means the sustainable index is still a broadly diversified instrument.

If the currency of a financial product and/or the charges involved differ from your reference currency, the returns and costs may be higher or lower due to currency fluctuations.

Risks of index funds

All offering documents, including the complete risk information, are available free of charge from a Credit Suisse client advisor or, if applicable, via Fundsearch.

• The funds do not provide capital protection. Investors may lose some or all of the capital they invested.
• The fund's investments are subject to market fluctuations.
• The funds do not achieve significant outperformance versus their reference indices.

Investments in emerging markets tend to be highly volatile

In cases where this report relates to emerging markets, we would point out that there are uncertainties and risks associated with investments and transactions in various asset classes as a result of or in connection with issuers and debtors established, located, or primarily engaged in business in emerging markets. Investments related to emerging market countries may be considered speculative; their prices tend to be much more volatile than those in the more developed countries of the world.

Investments in emerging markets should be made only by sophisticated investors or experienced professionals who have independent knowledge of the relevant markets, who have the ability to consider and weigh up the various risks presented by such investments, and who have the financial resources necessary to bear the substantial risk of the loss of such investments. It is your responsibility to manage the risks which arise as a result of investing in emerging markets and to manage the allocation of assets in your portfolio. You should seek advice from your own advisors with regard to the various risks and factors to be considered when investing in emerging markets.