Does the development in emerging markets offer an opportunity for ESG investors?
Does the development in emerging markets offer an opportunity for ESG investors?
Ethical emerging market bonds
The emerging market economies as a proportion of global GDP have expanded from 37% in 1990 to 55% in 2018. As a consequence of this evolution, debt issued by these developing countries has become an increasingly prominent fixed income segment with an enlarged footprint in investor portfolios. What are the sustainable options for emerging market debt?
As the first UCITS ETF of its kind, the UBS ETF J.P. Morgan USD EM IG ESG Diversified Bond UCITS ETF provides exposure to ESG-filtered USD denominated investment grade bonds issued by emerging market sovereigns, quasi-sovereigns and corporates, with the ultimate aim of the ESG overlay being to improve the overall sustainability profile. This innovative product offers a diversified exposure to investment grade emerging market debt that additionally delivers an ESG oriented investment profile. The index’s emphasis on ESG factors in this large and potentially returns-diversifying debt class enlarges the scope of possibilities for ESG focused investors.
The J.P. Morgan USD EM IG ESG Diversified Bond Index can provide a broadly diversified exposure to emerging market investment grade corporates, quasi-sovereigns and sovereigns. The ultimate aim of this ESG overlay is to improve the sustainability profile, whilst preserving the risk-return profile of the underlying universe.
- As the first UCITS ETF of its kind, it provides exposure to ESG-filtered USD denominated investment grade bonds issued by emerging market sovereigns and corporates.
- Tracks the J.P. Morgan USD EM IG ESG Diversified Bond Index.
- A refined building block for the construction of globally diversified portfolios.
- Focus on USD investment grade bonds along with the capping of single issuers increases diversification, reduces credit risk and eliminates currency risk.
- The ESG filtering follows the robust JESG methodology to select and overweight bonds meeting predefined ESG criteria.
Investing in emerging market bonds
Investing in emerging market bonds
The emerging market economies as a proportion of global GDP has increased from 37% in 1990 to 55% in 2018 (Figure 1). Along the way, debt issued by emerging market countries has become an increasingly prominent fixed income segment. The total index eligible EM debt outstanding exceeded USD 20 trillion as of July 2019 according to J.P. Morgan, which represents a 28% share of the total debt outstanding.
Emerging markets are characterized by economic and geographic diversity. For example, EM debt indices of J.P. Morgan provide access to 81 countries with the top five issuers being China, Mexico, Brazil, Russia and Turkey. EM debt can be issued in local currencies or in a hard currency (predominantly USD). The hard currency EM debt does not entail currency risks, while providing risk-diversification benefits when added to a developed markets portfolio.
Figure 1: Share of EM economics in the global GDP
Investment objective
Investment objective
The aim of the J.P. Morgan USD EM IG ESG Diversified Bond Index is to provide a broadly diversified exposure to emerging market investment grade corporates, quasi-sovereigns and sovereigns, which are filtered according to the J.P. Morgan ESG methodology ('JESG'). The aim of this ESG overlay is to improve the sustainability profile, while preserving the risk- return profile of the underlying universe.
Index construction methodology
The starting bond universe is based on combining two flagship emerging market USD indices covering the sovereign/quasi-sovereign segment (J.P. Morgan EMBI Global Diversified) and the corporate segment (J.P. Morgan CEMBI Broad Diversified), see Figure 2.
Figure 2: Index construction overview
Firstly, the J.P. Morgan USD EM IG ESG Diversified Bond Index only allows investment grade bonds, while for corporates it additionally requires an amount outstanding of at least USD 500 million. Secondly, the ESG screening is applied. Finally, a 5% capping is applied at the country level. The index rules also include a number of requirements on maturities as laid out in Figure 3.
Figure 3: Index criteria – J.P. Morgan USD EM IG ESG Diversified Bond Index
Instrument Type | Fixed and floating-rate securities. Excludes convertibles and inflation-linkers. | ||
Issuer Type |
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Remaining Maturity at Inclusion |
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Amount Outstanding | Corporate issues must have a face amount outstanding above USD 500mn. | ||
Currency | USD denominated only. | ||
Credit Rating | Investment grade based on the middle rating from S&P, Moody's and Fitch; when only ratings from two agencies are available, then the lower rating is assumed; when one agency rates a bond, then its rating has to be IG. | ||
Weighting | Market-cap multiplied by an ESG factor. |
ESG Filtering
ESG Filtering
An important aspect of index construction is the J.P. Morgan ESG filtering (JESG), which follows a three-step process.
The first step are the exclusions applied to corporate and semi-sovereign entities based on the United Nation Global Compact violations and involvement in certain activities.
The second JESG step introduces a positive ESG screening and reweighting to all index constituents. The bonds are classified into five bands based on ESG scores. The bottom quintile is removed from the index. The remaining bands are allocated different multipliers with the aim of overweighting the better-ESG rated companies. The final weight is determined by the market cap of the company multiplied by the ESG multiplier.
The third JESG step is to increase the weight of green bonds by allocating them a one-band upgrade.
Performance
Performance
The J.P. Morgan USD EM IG ESG Diversified Bond Index has delivered a return of 4.40% per annum in the period from 31 December 2012 to 31 May 2019 (Figure 4)1.
Figure 4: Performance attribution of J.P. Morgan USD EM IG ESG Diversified Bond Index, Period from 31 Dec 2012 to 30 Sep 2019.
It is shown how different components contribute to this overall performance. Allocation to the corporate sector boosts the overall return since returns on corporates (4.64% per annum) exceed those on sovereigns (4.58% per annum). Adding the investment grade filter reduces the returns by a total of 43bps, which is expected as it comes along with lower risks. Interestingly, the ESG filtering had no material impact on returns.
That is partly due to the high correlation between credit rating quality and ESG quality. Finally, the 5% country capping contributed 23 bps per annum to the overall performance. The resulting J.P. Morgan USD EM IG ESG Diversified Bond Index outperformed an index of IG sovereign bonds (J.P. EMBI Global Diversified IG) by 25 bps. The impact of ESG filtering combined with the 5% country capping is generally positive and leads to a modest outperfor-mance (Figure 5), which is steady over time.
Figure 5: Performance of J.P. Morgan USD EM IG ESG Diversified Bond Index, Period from 31 Dec 2012 to 30 Sep 2019.
The J.P. Morgan USD EM IG ESG Diversified Bond Index has a positive tracking difference as compared to the same index without ESG filtering and capping (Figure 6) and very low tracking error. The yield-to-maturity of the index is 3.54%, with a duration of 7.29, and average rating of BBB+ as of June 2019 (Figure 6).
Figure 6: Key metrics of the index
Conclusions
The J.P. Morgan USD EM IG ESG Diversified Bond Index is an innovative index that is tracked by the recently launched UBS ETF – J.P. Morgan USD EM IG ESG Diversified Bond UCITS ETF, available in USD and EUR-hedged share classes. With a robust and proven methodology, it offers investors easy access to investment grade emerging market bonds that conform to ESG requirements without compromising on investment objectives.
Current fund performance data and further product information are available at www.ubs.com/etf.
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