Viewpoints

Sustainable Investing in Local Currency Emerging Market Bonds

The growing market for ESG-labelled bonds in EM local currencies may offer a way to access EM local’s attractive yield potential within a sustainability-conscious framework.

Investor demand for bonds linked to environmental, social, or governance (ESG) objectives continues to grow, and both developed and emerging market (EM) issuers are responding. At PIMCO, we believe that ESG factors are an important addition to macroeconomic and credit considerations in EM sovereign risk analysis, and that ESG-labelled bonds from EM issuers can be a valuable addition to a sustainability-conscious approach to EM debt investing, while offering potential tangible benefits to EM countries and their populations. While the market for ESG-labelled bonds in EM local currencies is still in the early stages of its development, we believe the secular growth of EM local markets and rising supranational issuance will create attractive opportunities for investors to participate in the development of this nascent asset class.

ESG in emerging markets: challenging at times, but worthwhile

PIMCO has long believed that environmental, social, and governance factors are important to consider when assessing emerging market debt. Our in-house analytical research finds that ESG factors tend to be significant drivers of sovereign credit risk and that changes in governance variables in particular historically have been statistically relevant to credit spreads and currencies, especially in emerging markets.

ESG considerations may become even more important for EM in the years ahead. On the environmental side, many EM countries are amongst the most susceptible to the effects of climate change, given exposure to both physical and transition risks. The UN estimates that by 2030 the annual climate change adaptation costs for developing countries to mitigate these risks could reach $300 billion a year. More broadly, meeting the Sustainable Development Goals (SDGs) by their 2030 target date would require closing an annual financing gap of $3.7 trillion in developing markets, as estimated by the Organisation for Economic Cooperation and Development (OECD).

There is a major need for funding in EM, but ESG-conscious investors also need to be aware that from an ESG perspective, some EM countries face more challenges than developed market (DM) countries (although it’s important to note that many EM countries – such as Chile or Croatia – are at par with DMs on select ESG metrics). This further reinforces the importance of incorporating ESG factors in the risk analysis of EM sovereigns, in addition to the standard macroeconomic and credit analysis.

Given these considerations, ESG-labelled bonds may be a natural vehicle for ensuring that the capital required to address EM’s most pressing ESG issues is allocated appropriately. Importantly, the ESG frameworks underlying these labelled issuances are typically consistent with industry standards (for example, those from ICMA – the International Capital Market Association), including commitments on reporting and increased oversight on expenditures.

The shifting composition of the EM ESG-labelled bond universe

The ESG ecosystem in EM has grown considerably over the past five years, broadening in size, scope, and complexity. Bolstering this trend is the increasing implementation of climate-related disclosure requirements, issuance of taxonomies and frameworks, and announcement of climate targets across EMs. Hard currency issuance (i.e., in U.S. dollars, euros, or British pounds) has historically been the dominant driver of growth in the EM ESG space, but issuance in local currencies is quickly catching up, growing from $4 billion in 2015 to $83 billion in 2021 (see Figure 1). As of Q2 2022, issuance in local EM currencies was already 55% of total EM ESG-labelled issuance. We see broad scope for these numbers to grow given that EM local markets are over six times larger than external markets, and since much of the ESG-labelled local issuance has come only from a few key geographies so far.

Figure 1: The graph shows the amount in billions of emerging market local currency ESG-labelled bonds issued each year from 2008 to 2022, as of 30 June 2022. The amount of issuance has risen from a very low level in 2008, to $4 billion in 2015, and to $83 billion in 2021. By halfway through 2022, $55 billion had been issued. The source is Bloomberg BNEF, and the graph is for illustrative purposes only.

Historically, local currency ESG-labelled issuance has been dominated by Asian countries including China; which alone makes up 45% of total issuance (see Figure 2). However, other regions are seeing significant growth in the space – Chile has been at the forefront of local currency ESG issuance in Latin America, while Poland and South Africa have been amongst the most active geographies in EMEA. Given the growing demand for these types of bonds, we expect the supply outside of Asia to continue to rise going forward.

Figure 2: The pie chart shows the historical issuance of emerging market local currency ESG-labelled bonds by region. It shows that issuance has been dominated by Asian countries including China. The breakdown is as follows: Asia excluding China makes up 45% of total issuance; China alone makes up another 45%; MENA 7%; and Latam 4%. The source is Bloomberg BNEF, as of 31 December 2021, and the chart is for illustrative purposes only.

EM governments are a major source of this issuance, followed by government development banks, government agencies, and EM corporates (especially financials and utilities). International financial institutions like the World Bank and the Inter-American Development Bank are also increasingly prominent issuers. In terms of tenor, ESG local currency issuance thus far is concentrated in the 0–7 year category, which accounted for almost 85% of all issuance in 2021.

The large and longer-term financing needs for emerging markets to meet their SDGs mean there is substantial scope for ESG-labelled issuance to continue to scale up and diversify over time.

Supranationals: a growing presence in EM local ESG

Supranational issuers (entities formed of – or working across – more than one country; examples include the World Bank and the Asian Development Bank) can represent an interesting opportunity for investors looking to allocate to EM ESG bonds denominated in local currencies. Supranational entities often have objectives that align with ESG goals, such as reducing the impact of climate change or supporting underserved populations. Furthermore, from a credit fundamentals perspective, supranationals typically have a very high credit quality, often an AAA-rated balance sheet, modest leverage, and strong support from developed market governments.

Supranationals have issued ESG-labelled bonds in a range of EM currencies thus far, including the Mexican peso (MXN), Hungarian forint (HUF), Indonesian rupiah (IDR), and Indian rupee (INR), Polish zloty (PLN), and South African rand (ZAR), and there are likely to be more in the future. Some of these supranational bonds actually trade with a higher yield than their respective governments’ curves, despite having a much higher credit quality due to their lower liquidity profile, meaning that investors can expect to receive a liquidity premium. Accordingly, for investors who have space in their portfolios for securities with a longer investment horizon, supranational debt issued in EM local currencies can be a compelling ESG-labelled alternative to local currency government bonds.

PIMCO and the future development of the market for EM ESG bonds

As long-term investors in emerging markets, PIMCO has for many years actively partnered with supranationals and EM governments to develop local emerging fixed income markets.

Over the past decade, we have observed a secular trend among EM countries to issue more of their debt in local currency, driven by a preference to deepen the local investor base, to develop the local capital markets, and to seek to avoid the dangers of a mismatch between revenues and debt obligations. ESG-labelled EM local currency bonds are a natural extension of this process, which calls for collaboration between financial market participants and EM sovereign and supranational entities. By partnering with investors on ESG frameworks and gathering feedback on approaches to ESG, countries can look to identify gaps, address investor concerns, and thereby accelerate the development of this market. For example, PIMCO worked with the Central Bank of the Dominican Republic to expand its currency hedging infrastructure, helping support orderly market conditions and make the local market more attractive to foreign capital. After assisting local authorities in constructing the new instruments, PIMCO was the first foreign investor to transact in them.

PIMCO’s longstanding relationships also allows us to act as anchors in sovereign, supranational, and corporate local bond deals. For example, in 2021 PIMCO partnered with the United Nations Economic Commission for Africa (UNECA) and the Development Bank of Southern Africa (DBSA), lending the issuer 3 billion ZAR (around $210 million) to support renewable energy generation and transmission projects across Southern African countries. This deal added renewable energy lending capacity to DBSA, while allowing PIMCO to deepen its long-term commitment to supporting Africa’s transition away from fossil fuels.

Investment takeaways

An allocation to emerging market local bonds may make sense for a wide range of investors given the potential for compelling valuations of EM currencies and attractive real yields versus developed markets. Given the ongoing development of the ESG-labelled EM local bond market, investors have another tool to access the sector in a sustainability-conscious way.

Learn more about ESG investing at PIMCO on our dedicated webpage.



1 PIMCO’s internal analytical research suggests there is a statistically significant relationship historically between ESG variables (particularly governance) and real exchange rates.


The Author

Pramol Dhawan

Head of Emerging Markets Portfolio Management

Lupin Rahman

Head of EM Sovereign Credit

Michael Davidson

Portfolio Manager, Emerging Markets

Naki Nartey

Emerging Markets Product Strategist

Related

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Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty and operational risk. Investments in these markets may expose the fund to larger gains or losses. Changes in exchange rates may cause the value of investments to decrease or increase. Changes in interest rates will usually result in the values of bond and other debt instruments moving in the opposite direction (e.g. a rise in interest rates likely leads to fall in bond prices).

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