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Investing in Asia fixed income with an ESG focus

In this article, Geoffrey Lunt, Senior Investment Specialist, discusses how investing in Asia with an ESG focus has the potential to make a great impact.
2022年03月01日
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    Key takeaways

    • Asia has become by far the world’s biggest polluter and urgent action is needed. The financing of Asia’s sustainable transition will be hugely expensive, with the United Nations forecasting that the region requires an additional investment of USD 1.5 trillion annually
    • Not surprisingly, the issuance of sustainable bonds has soared in recent years and is set to make new records in the years to come, providing a major boost to Asia’s debt capital market and increasing choice for investors with an ESG focus
    • The theme of ‘common prosperity’ which has featured so heavily in Chinese policy making in recent times has social considerations at its core. China’s agenda to improve its social framework is trickling down to individual companies
    • We believe that although an ESG enhanced strategy will inevitably narrow your investment universe, we still have enough choice to populate good value, well diversified portfolios which should perform well over the medium to long term
    • The diversity and stage of development of the economies and markets in Asia, together with the vast size and population of the region, means that specialist expertise is required to effectively understand and analyse ESG factors. But the prize is potentially substantial
    • In order to put together a credible and attractive investment proposition to our clients, we not only leverage our knowledge of each individual issuer, but also engage with current and candidate investee companies in order to set out our expectations of ESG standards and improvement

    If you’re going to invest with an ESG focus anywhere, it may as well be Asia

    One of our clients recently asked us why our Asia ESG fixed income strategy invested significantly in China when it is well known that China is by far the largest producer of CO2 emissions. It raises an interesting philosophical point. What is ESG investing actually for? Is it to say that your portfolio is clean of any institution which doesn’t meet certain ESG standards and therefore not contributing to transgressors? Is it to enhance the risk management of your investments and avoid financial loss? Or is it to be able to engage with investee companies in order to coax them in the right direction and thereby in aggregate improve the standards across economies? In fact, we believe it is all three of these, but it is also probably fair to say that the latter two are more important in less developed economies where regulations tend to be less stringent and the awareness of ESG challenges is so far likely at a lower level.

    Within this framework, we can see that investing in China and other parts of Asia with an ESG focus has the capacity to make as great an impact as investing anywhere, and probably more. One blunt (and not very comforting) set of statistics below shows the dramatic increase in Asia’s CO2 emissions in the last 50 years to the point that it now produces nearly half the world’s total.

    Fig. 1: CO2 emissions

    Fig. 1: CO2 emissions

    Source: Statista, January 2022. For illustrative purpose only.

    Despite these rather grizzly numbers, there is good news both on the environmental front and also for bond investors keen to contribute to a better ESG landscape in Asia. Governments are undoubtedly waking up to the challenges. As a friend of mine who lives in a large Asian emerging market city explains – the leaders of countries may enjoy more luxurious surroundings and more expensive food, but their children breath the same air. I don’t think this is a frivolous point – any of us who have been regular visitors to the big cities in Asia can appreciate how the pollution on some days is literally in your face, not a recondite statistic, and significantly erodes the quality of life for everyone.

    Consequently China, for instance, has announced its aim to hit peak emissions before 2030 and achieve carbon neutrality by 2060 by reducing carbon and energy intensity, moving to cleaner energy sources and increasing forest coverage. All other major Asian countries have similar targets and timeframes, although the more developed countries tend to have more ambitious targets.

    Fig. 2: Asia’s net zero and emission reduction targets should support ESG improvement of individual issuers and labelled issuance

    Fig. 2: Asia’s net zero and emission reduction targets should support ESG improvement of individual issuers and labelled issuance

    Source: HSBC Global Research, Government energy ministries, BP, ADB, HSBC, November 2021. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purpose only.

    The financing of this transition is going to be vastly expensive. The United Nations forecasts that Asia requires an additional investment of USD 1.5 trillion annually to meet its Sustainable Development Goals by 2030. Not surprisingly, then, the issuance of green bonds – and indeed other sustainability and sustainability linked bonds – has soared in recent years and set to make new records in the years to come. This is a boost to Asia’s debt capital market, which is less developed than those in other parts of the world.

    Fig. 3: Record year in Asia USD green bond supply

    Fig. 3: Record year in Asia USD green bond supply

    Source: HSBC Global Research, Bloomberg, September 2021. For illustrative purpose only.

    Beware the Greenwash

    Just as in any other market which is new and growing strongly, however, we need to be careful. The phenomenon of ‘Greenwashing’ – basically calling your bond ‘Green’ when its environmental credentials are not robust or even non-existent – is well accepted. Disingenuous treasurers may be only too willing to ride the wave of accelerating ESG demand to secure cheaper and more diversified funding from naïve investors, so it is essential to conduct further due diligence if investing in these assets is actually going to help finance the transition.

    The International Capital Markets Association sets The Green Bond Principles (GBPs) which are standards for issuers, although they are voluntary. We strongly prefer green bonds which are verified by an independent and recognised external reviewer as genuinely green and abiding with the GBPs. We need to be satisfied that at least 90 per cent of the proceeds will be allocated to eligible green projects, that reporting of continued compliance is timely and transparent, and that any energy efficiency is beyond just cost saving and business as usual. Exceptions to these rules can be made, but only when we are satisfied through engagement with investee companies that compliance will be achieved within a reasonable timeframe.

    Beyond the Environmental

    The theme of ‘common prosperity’ which has featured so heavily in Chinese policy making in recent times has social considerations at its core. Any investor in China is well advised to pay close attention to policy direction and to realise that non-financial considerations will often take priority where political objectives are at stake, and that China does not endorse an unfettered capitalist free market unless it happens to support its social objectives. This fits well with an investment strategy with a strong ESG focus where government policy and investor interests are aligned. Clearly there can be different opinions on what makes good social policy, but the goal of ‘common prosperity’ in its broadest sense can certainly be seen as consistent with an improving social environment. On a practical level, this agenda to improve the social framework is trickling down to individual companies. We see, for instance, that the safety record of Chinese real estate developers is improving in aggregate, but that the pace of improvement on an issuer level is different. Our in-depth knowledge of the sector and our ongoing engagement with the issuers give us insights into their varying attitudes and policies and enable us to discriminate between those taking the situation seriously and those who are paying lip-service or just ignoring the problem. Importantly – just as in the case of green bonds – we require full transparency and ongoing verifiable disclosure to endorse our opinions.

    As is often the case with Asia, it is difficult to make generalisations, and the social challenges facing each country is different. The political, religious and ethnic histories of many Asian countries are exceptionally complicated and have to be viewed through a nuanced lens with a deep understanding of the background to the social and economic frameworks which may be less familiar to investors in the western developed markets. Issues such as gender and ethnic equality are at a different stage of evolution in parts of Asia, but just as with environmental challenges, the scope for improvement – and therefore the impact a socially aware investment policy can make – is significant.

    Key considerations in governance

    It is probably fair to say that the close scrutiny of governance issues has always been essential to the management of credit portfolios long before the acronym ‘ESG’ came into existence. The resilience of the structure of the entity you are lending to and the exact nature of the liability and security are integral to fundamental credit analysis. High profile failures of governance have highlighted the extreme financial cost of ignoring such factors over the long history of debt capital markets.

    The issues facing Asia in this regard are again complicated. The diverse geography with different (sometimes unproven) legal systems, governance frameworks, accounting principles and disclosure rules all make it difficult to manage with a ‘one size fits all’ approach. Meanwhile, the ownership of companies, where a large proportion of the economy is either government or privately owned, can make structures and ultimate liability opaque. In recent years, we have also seen a generational shift in wealth, especially in China and India, where companies have passed from the family patriarch/matriarch to their children, which can fragment the company or put it into the hands of either uninterested or less competent possession. The weakening of the implicit guarantee for state owned companies and indeed the broader market in China has been an important theme in the Asian credit market in the past few years, including during the recent real estate funding crisis, where some companies may have believed that the government would step in to provide greater support for systemically important institutions. There is also the complex issue of structural subordination of offshore bondholders, where ownership rights may be more difficult to assert from beyond a country’s borders.

    Are we sacrificing returns?

    The arguments for the financial benefit of investing with an ESG focus and therefore establishing a more robust risk framework are well circulated, as are the counterarguments of ‘Greenium’ and the high demand for ESG fixed income assets resulting in lower yields. Historical empirical evidence tends to suggest that in this case, you probably can ‘have your cake and eat it’ – in other words, you can achieve similar returns with an ESG tilt as without. Our qualitative view, backed by quantitative research, is that although an ESG enhanced strategy will inevitably narrow your investment universe, we still have enough choice to populate good value, well diversified portfolios which should perform well over the medium to long term – even with a relatively small credit universe such as Asia. Inevitably the resulting sector skews and concentrations could mean that an ESG strategy that features exclusions may perform differently over short timeframes for idiosyncratic reasons, but figure 4, which compares the returns of the JPMorgan Credit Index and the JPMorgan Asia Credit ESG Index (which tilts to better ESG scorers and has standard sectoral exclusions) shows no material difference since the inception of the latter.

    Fig. 4: Performance – statistically irrelevant difference between ESG and non-ESG index historically

    Fig. 4: Performance – statistically irrelevant difference between ESG and non-ESG index historically

    Fig. 4: Performance – statistically irrelevant difference between ESG and non-ESG index historically

    Source: JPMorgan, HSBC Asset Management, data as of 31 January 2022. Annualised volatility is based on weekly returns. JACI ESG refers to JPMorgan ESG Asia Credit Index, and JACI refers to JPMorgan Asia Credit Index. Investment involves risks. Past performance is not indicative of future performance. For illustrative purpose only.

    Managing ESG enhanced Asia credit portfolios with a combination of qualitative and quantitative analysis

    In order to put together a credible and attractive investment proposition to our clients, we need to not only leverage our knowledge of each individual issuer, but also engage with current and candidate investee companies in order to set out our expectations of ESG standards and improvement. Just like with conventional credit analysis, there are no short cuts and it is labour and talent intensive. The credit analyst responsible for the name is the first line of contact, and they will conduct their ESG assessment alongside their financial analysis. But we also need ESG experts who not only set the parameters for ESG standards, but can also conduct further and more intensive due diligence when the need arises. This process needs a further layer of oversight of our most senior investment professionals to ensure that standards are consistent and compliant with policy across the firm, and to be the ultimate arbiter of conflicting subjective opinion.

    We also need a framework for the strategy which allows sufficiently active, diversified and creditworthy portfolios that deliver good risk adjusted returns. These strategies should also be able to withstand scrutiny via third party, independent scoring methods to ensure that they are complying to demanding ESG standards. This requires a fair degree of quantitative analysis in order to ascertain the optimal parameters for ESG thresholds. Setting the bar too high risks having too small a universe to deliver a well risk adjusted portfolio, while setting too low undermines the portfolio’s ESG credentials. These parameters need to be reviewed regularly to take into account the evolving characteristics of the asset class.

    Conclusion

    The nature of Asia and the Asian credit market means that there are special complications and no short cuts to identifying and managing ESG risks and opportunities. The diversity and stage of development of the economies and markets in Asia, together with the vast size and population of the region, means that specialist expertise is required to effectively understand and analyse ESG factors. But the prize is potentially substantial. To put it bluntly, it doesn’t matter very much what happens to the environmental transition in the rest of the world unless Asia joins in, and in order to do so it needs vast amounts of funding. Meanwhile the scope for improvement in Social and Governance standards is considerable. So if you are going to invest with an ESG focus anywhere, Asia may well be your best option.

    Investment involves risks. Past performance is not indicative of future performance. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only.

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