Quasi sovereigns, bonds issued by fully state-owned companies, account for a substantial slice of the emerging markets (EM) fixed income market. The largest issuers have tens of billions of dollars of debt—three of the five largest corporate debt issuers from EM are fully state owned. To many investors, they are an attractive way to enjoy a level of safety similar to that of sovereign bonds, but with a higher yield. This is all the more enticing at a time when yields for many sovereigns and investment-grade corporates are low.

But we take a different approach: In this ESG Insight we explain why we believe investing in fully state-owned companies can represent an ESG risk in EM debt, and why we prefer corporates over quasi sovereigns. Currently, Nordea’s Emerging Stars Bond Strategy does not invest in any fully state-owned companies, despite them representing ~20% of the strategy’s benchmark (around 80% of the benchmark is made up of sovereign bonds), the J.P. Morgan EMBI Global Diversified.

We prefer corporates over quasi sovereigns

With increasing awareness among issuers and innovation in the market for ESG-related bonds, it is an exciting time to be an ESG-focused investor in EM corporate debt. Since the beginning of 2020, we have been complementing our ESG-focused EM sovereign bond portfolio in Nordea’s Emerging Stars Bond Strategy with the addition of corporate bonds.

Today, our corporate bond investments focus on privately-owned (meaning not state-owned) issuers from the emerging markets. This is because there is much to excite us in this investment universe. In particular, many corporate issuers exhibit strong or improving ESG practices and solid financial outlooks. In addition, we find many privately-owned companies with business models that contribute positively to the United Nations’ Sustainable Development Goals (SDGs) – a fact that should allow them to have access to capital in the future. The SDGs are 2030 targets for the world to achieve decent economic growth and prosperity for all, without harming the planet. We take them seriously as EM debt investors in part because we expect companies aligned with the SDGs to have easier access to capital in the future. For example, as investors become increasingly concerned about sustainability, a coal-based utility or oil producer will have fewer financing sources than many other companies.

On the flip side, all of the quasi sovereigns on the J.P. Morgan benchmark are fully state-owned. Given the absence of external shareholders, many of those companies follow politically driven business strategies, lack independent oversight, are less efficient and prone to corruption. In other words, they often score poorly in ESG terms—which translates into risk for the investor. Commodity producers like oil & gas companies account for a large slice of fully stateowned companies, given the strategic importance of the sector for many emerging markets countries as well as its high capital requirements. The lack of ESG transparency and the inherent sector tilt make fully state-owned companies in EM a difficult investment universe for ESG focused funds, and in particular for our strategy. Nevertheless, with around 90 issuers to choose from in the benchmark index, the universe of fully state-owned companies is comparably small and thus does not prohibit us from finding more appropriate investments.

What we like in EM corporate debt: strong ESG practices and SDG-aligned business models

“Financials” make up the largest sector among privately-owned corporates, accounting for 30% of the
market capitalization of the J.P. Morgan CEMBI Broad Diversified benchmark index, an EM corporate bonds benchmark index. While we place the same ESG demands on them as we do on non-financial corporates, we additionally have a very strong preference for banks that have signed the Principles for Responsible Banking, of which Nordea is a founding signatory. The principles were launched by the United Nations Environment Programme Finance Initiative in 2019 and require signatories to align their “business strategy to be consistent with and contribute to individuals’ needs and society’s goals, as expressed in the SDGs, the Paris Climate Agreement and relevant national and regional frameworks”¹. Banks that fall in this category include BBVA Bancomer from Mexico and Bancolombia from Colombia.

We are also enthusiastic about recent developments in the ESG-related bond issuances within the emerging markets. While green, social and sustainable-bonds (which require the issuance proceeds to be used for green projects, social projects or a combination thereof) issuance has grown rapidly in recent years, we have seen the first issuance of a sustainability-linked bond from an EM issuer. Suzano, the world’s largest pulp and paper producer from Brazil, issued a bond in September that links the coupon rate to greenhouse gas emission targets. The coupon rate will increase by 25 basis points should the company not achieve a defined level of emission reduction by 2026 (the maturity year of the bond is 2031). We like the sustainability-linked structure for linking sustainability goals to financial incentives; and the transaction has paid off for Suzano with the bond trading with a lower spread than “conventional” bonds from the same issuer.

One other emerging trend that particularly interests us is the involvement of multilateral development banks in new bond issuances. Instead of rolling over existing loans or providing new loans to issuers, they are buying a slice of their bond issuances as co-investors with asset managers from the private sector. We welcome this development. It gives issuers that previously had to rely primarily on development financing access to private capital; it gives bond investors exposure to companies they perhaps could not have funded before, given they were not present in the bond market. An example of such a transaction is a bond issued by Georgia Global Utilities, a water utility and renewable energy producer from Georgia that issued its inaugural bond in July of 2020. Investors in the USD 250 million bond, which is also the first green bond issued out of Georgia, included Deutsche Investitions und Entwicklungsgesellschaft mbH (“DEG”), the Netherlands Development Finance Company (“FMO”) and the Asian Development Bank (“ADB”).

The issue with fully state-owned companies

Fully state-owned companies in emerging markets are often less efficient because they frequently are run with political objectives that can threaten the commercial goals and sometimes supplant them completely. Since key management personnel usually gets nominated by the current government, incentives for long-term business planning are low. Additionally, the lack of independent oversight makes fully state-owned companies prone to corruption. In a study that includes stateowned companies from developed as well as emerging markets, the IMF finds that state-owned companies in countries with a low control of corruption have a significantly lower profitability than their private sector counterparts. As the authors of the study put it: “Our analysis also indicates that state owned enterprises (SOEs) are more affected by a corrupt environment than private firms—in a low corruption environment, SOEs can be as, or more, productive than private firms.

Our results support the view that when governance is weak, SOEs are more vulnerable likely due to the proximity to government officials and politicians and weaker oversight”³. In another publication, the IMF concludes that “SOEs generally have low productivity, distort competition, and can be plagued by corruption. SOEs have fallen short, particularly in developing countries, in providing basic services, such as access to safe water, sanitation, and reliable electricity, to the entire population and further. The model for using and managing SOEs should be strengthened in many countries. The stakes are high because SOEs provide core economic services and could be an important vehicle for achieving the Sustainable Development Goals⁴”. Poor management, short-term planning coupled with often high pay-outs to the government (in the form of dividends or taxes) means that for many of the fully state-owned companies leverage is high – a fact that puts pressure on their balance sheets, particularly given the prices of many major commodities have declined over the past years.

In theory, fully state-owned companies enjoy one consolation for all this interference: the state will step in as the lender of last resort if they cannot service their debts. This supposition of government backing is a key reason why they are included in several emerging market sovereign debt benchmark indices. Ratings agencies subscribe to this view, and give them credit ratings based on this assumption – reasoning that default risk is reduced due to the sovereign backstop. There is rarely an explicit guarantee, but rating agencies see it as an implicit one. To many investors, bonds of fully state-owned companies are therefore satellite bonds orbiting round sovereigns; this explains why their pricing often moves in line with sovereigns. In times of low yields this has benefited them: yields on bonds of fully state-owned companies on aggregate have fallen in 2020 because yields on sovereigns have done so.

And indeed, cases of debt restructurings for fully state-owned companies are rare. We foresee however, that for an increasing amount of fully state-owned companies, investors could start questioning the ability and/or the willingness of their sole shareholder to support the company, decoupling spreads for individual issuers from those of their respective government bonds in the future. Increasing leverage on sovereign balance sheets, impacting the ability to support, might amplify this development. We already see cases of this, as evidenced by the spread of individual stateowned companies’ bonds widen to their respective government bonds. Higher funding costs as well as a global push to redirect capital towards more business models that support the UN’s SDGs might make the refinancing more difficult for many of those issuers.

There is another crucial reason why we do not invest in fully state-owned companies currently. Many of them have low levels of non-financial disclosure. Because of a lack of information, the majority of the companies do not have ESG ratings from third party rating providers, such as MSCI. According to our analysis, more than 70% of index eligible of fully state-owned enterprises do either not have a corporate-level rating or it is very low (“B” and lower).

We exclude ESG laggards from our emerging market debt strategy on financial grounds, given a poor ESG track record is both a sign of a badly run company and a risk in itself. Think of the USD65 billion compensation paid by BP after the Deepwater Horizon oil spill – a spill caused by the failure of eight different safety systems.⁵