COP27: Should we invest in emerging market bonds?

Previous Conference of the Parties (COPs) focused on understanding how to finance net-zero transitions but this year’s COP27 will be remembered for discussions around “loss and damage” funding for emerging market (EM) countries.

This is because EM countries are more affected by environmental changes and it was identified that rich countries and development banks need to up their funding of developing countries by $1 trillion a year to combat climate change.

There are several ways in which this extra money can be raised. It can consist of direct donations from developing nations, lending, private investments or thematic bonds such as green bonds. There’s pros and cons to each finance option.

Financing net-zero transition through lending is becoming extremely expensive for EM countries, especially in a monetary tightening environment, where interest rates and spreads are increasing and EM currencies are depreciating against the dollar.

For private capital, the current instruments of ESG investing are still not enough to solve this issue, especially because several ESG frameworks are focussed on ESG rating. These frameworks focus on climate and social risks, which might be generally low for EM countries. 

Despite still having many limitations and potential risk, green bonds and sustainability-linked bonds (SLBs) might address different barriers for issuers and investors.

What is a green bond?

Green bonds are debt instruments that help to raise funds specifically for green projects. This can be anything from renewable energy initiatives, clean transportation to promoting sustainability in conservation.

It’s common to see a green bond offering in developed markets. In the UK, for instance, savers can now earn 3% interest on Green Savings Bonds which were launched in October 2021 and offered through Treasury backed National Savings & Investment. European countries like France, Italy, Germany and Belgium also have their own green bonds.

Developing nations are starting to consider their own green bond versions but a big concern is meeting institutional investors’ stringent criteria. Institutional investors (banks, wealth managers, asset management companies, etc.) will typically only invest in green bonds if their strategies meet their sustainability rules. 

These strategies vary greatly as there’s currently no standardisation.  Overall, when it comes to criteria (which is also different between investors) you’ll find that while one green bond meets up to an investor’s standard, another may not meet the grade.

Another limitation is that the interest rate of green bonds is generally aligned to classic bonds, so they are not able to offer a solution to the current monetary tightening we are experiencing. 

What are SLBs?

SLBs are bonds where the proceeds aren’t ring fenced to green or sustainable projects. The proceeds could be used for anything. 

However, SLBs have key performance indicators (KPIs) that are linked to pre-defined environmental, social and governance targets. SLBs might allow EMs to benefit from lower interest rates, because they are linked to ESG KPI. Essentially, SLBs are not as strict with their green mandates as green bonds and it opens the market up to more issuers. 

The downside to SLBs is that not all private investors are interested in reducing their returns to finance climate or social transition so they may not appeal to all.  

Choosing where to invest

When it comes to EM debt it’s very difficult to apply the usual ESG (environmental, social and governance). This is because the project the bond backs could be noble in its intentions, but there could be other reasons (underlying or external) that could put investors off.

For example, a green bond could be created to fund a renewable energy project on several farms in a village in Pakistan. However, investors may not want to expose their money to that country because of its unconvincing growth policies.

There are other metrics that may need to be considered too – such as the exclusion of polluters. While heavy emitting companies, such as oil and aviation businesses, have been traditionally left out of the green bond market, some are reconsidering this stance as many of these big polluters are seeking money to fund their ‘transition to green’ plans.

Transition to zero

Whether to fund companies and EMs as they transition to zero is an ongoing debate in the world of ESG portfolio management. This is because some big polluters want to change their ways to help the environment, but they can’t do so without the money.  

The question for asset managers and wealth managers is: do they support these countries and companies financially to make that transition or stubbornly refrain from investing in them until they are fully ESG compliant? In some respects, there should be a balance. How else could some of these companies or EM countries meet their sustainability goals if they don’t have the money to do it. 

We’re increasingly seeing more willingness to fund climate transition plans. For example, earlier this year a group of 12 UK pension funds convened by the Church of England (CofE) Pensions Board teamed up to find ways to support the transition in EMs. They include the £83bn Universities’ Superannuation Scheme and the £57bn BT Pension fund to name but a few.

It’s initiatives like this that open investors, like Moneyfarm, to the idea of looking at the transition ambitions of EMs and not only focus on their current social, environmental metrics and the risks. It’s a big undertaking but it’s a growing trend and shouldn’t be ignored, particularly if it offers our clients value.

But there’s still lots to be done. ESG strategies in equity and fixed income bonds are more advanced and complete while EM governments still lag in producing more robust ESG strategies. This means that quality concerns around any green bonds or SLBs that are launched, could still be an issue. But it’s certainly a space to watch!