Sustainable investing in Asian fixed income

Market interest in sustainable investment in Asia is rapidly growing. In Japan, assets owned in sustainable investment strategies quadrupled between 2016 and 2018, making the country the world’s third-largest sustainable investing market after Europe and the United States.¹ This growth in investment strategies has been accompanied by growth in sustainable issuance. Very few green bonds were issued in China before 2016, but in 2018 China represented 18% of global green bond issuance, and the Asia-Pacific region accounted for 26.7%.² Meanwhile, a steady rise in green, social, and sustainability bond issuance has led this segment to represent 3.6% of the $US1+ trillion J.P. Morgan Asia Credit Index (JACI), which comprises U.S.-dollar denominated sovereign and corporate bonds issued in Asia.³

This growth has been driven by numerous factors—most notably by the imperatives of climate risk, recent and anticipated regulatory changes, and issuers across the Asia-Pacific region looking to diversify their sources of financing to global investors. But the trend has had and is likely to continue to have its share of growing pains. Even as major Asian asset owners have aligned themselves with the UN Principles for Responsible Investment (PRI) and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), asset managers in the region continue to lag their global peers in the depth of skills and resources available to integrate environmental, social, and governance (ESG) concerns into daily investment practices. A recent survey estimates that less than 10% of managers in the region systematically adjust their models based on ESG information.⁴ And as scientific reports on the urgency of climate risk make headlines around the world, stakeholders are beginning to seriously consider the scale and pace of necessary change.

As environmental and social trends are changing companies’ business models, bondholders are grappling with the credit risks and opportunities these trends create in their portfolios. In our view, these conditions indicate a strong opportunity for active managers that can take advantage of dynamics that may not be captured in an index. As regulators push investors to think through issues like the impact of climate risk on their portfolios, asset owners are looking for help to accurately measure and manage the implications. As the path to sustainability begins with better disclosure, asset managers are using corporate engagement strategies to gain greater insight into issuers and foster better information flow, which could improve company sustainability performance and improve the resiliency of client portfolios over time.

Considering the regional specificity of ESG factors in Asia, we believe that the investment case for sustainable fixed-income investing rests on three pillars:

• The need to contextualize and integrate ESG data. Third-party sustainability rankings may be helpful inputs to ESG research, but they require supplemental interpretive analysis. We don’t view ESG integration as a static activity, but believe that adaptable and active approaches can reveal emerging catalysts that may drive investment performance in the region.
• The complexity and importance of governance in Asia. Corporate governance structure in Asia tends to differ from other parts of the world, with a higher proportion of family and state-owned businesses and common cross-shareholdings. This has long been incorporated into credit analysis in the region, but it underscores the need for investment managers to have local resources and expertise.
• Capturing the sustainable development opportunity in the region. The Asian growth story is well known. Rapid industrialization, exports, and high investment and saving rates have driven above-average economic growth and a rising middle class. And yet 61% of the world’s population lives in Asia⁵ on about one-third of the Earth’s land surface,⁶ and that population is rapidly aging.⁷ We expect the market to reward companies that provide sustainable solutions in this context, and we believe having a framework to proactively identify them is the key to capturing these opportunities while supporting the continued growth potential in the region.  

The foregoing conditions make a strong case for sustainable investing in Asia, where the central challenge is finding ways to build portfolios resilient to ESG risks and receptive to ESG opportunities.

In order to sharpen our focus on relevant ESG factors for Asian credit investing, one of our credit teams in the region has developed an ESG framework that systematically quantifies how ESG factors affect the team’s internal risk-rating decisions. The team’s ESG due diligence identifies environmental and labor best practices, and then applies an adjustment to an internal risk-rating system for companies where lagging these standards could create material risks. This allows the team to categorize issuers in the coverage universe, assigning a risk-intensity ranking to issuers into one of four risk-intensity categories: very high, high, moderate, and low for each of the E, S, and G factors based on various quantitative and qualitative attributes.

Application to Southeast Asian palm oil

Our practices of ESG integration and engagement within our fundamental credit research process model how we’ve developed our ESG research practices to be sensitive to local contexts. A recent and topical example concerns our work in the area of palm oil plantations, which have material environmental and social exposures.

One Southeast Asian palm oil producer identified as high risk was suspended from selling to European buyers in 2017 after an international complaint about unsustainable plantation development. This immediately affected numerous international contracts, changing both equity and bond valuations.

In contrast, another company assessed as moderate risk is diversified with non-palm-oil business lines and remains more insulated from the global market, which is where demand for certified sustainable palm oil is expected to grow alongside Roundtable on Sustainable Palm Oil (RSPO) membership. Therefore, applying the proprietary ESG research and materiality framework has become an important input into the team’s investment decisions.    

Corporate engagement in Asia remains an emerging practice, even among equity shareholders. While engagement by bondholders is even less commonly practiced, credit often represents a larger portion of a company’s capital structure. This is especially true in credit-intensive industries such as utilities, automakers, and manufacturing that have high exposure to long-term environmental risks and opportunities. We believe we can build long-term relationships with issuers through partnership and collaborative discussion. Outside Japan, we believe it helps to have one of the world’s largest Asian fixed-income organizations supporting us, including on-the-ground proprietary credit research and ESG team members based in Greater China and across the ASEAN region.

As we speak with issuers on various ESG topics, we gain insight into their business model and strategy. Through our engagements with companies, governments, and regulators, we leverage our information advantage in a diverse array of local markets, languages, and cultures. We’re also able to share our view on industry best practices on sustainability issues based on our research and experience. We believe that engagement carries with it the potential to protect and grow invested capital, while also helping to shape key issues and support the resiliency of capital markets.

Board diversity and governance in Hong Kong

We believe diversity on boards encourages better leadership and better corporate governance, and ultimately increases corporate performance and competitiveness. Manulife Investment Management is one of the founding members of the Board Diversity Hong Kong Initiative, which aims to put this belief into action by encouraging diversity at all levels of listed companies in Hong Kong.⁸

As part of our commitment, we engaged with a Chinese technology and media company listed in Hong Kong on the topic of board diversity that had had an all-male board since its initial listing. The company explained how independent directors are nominated, and we shared our view that diversity of representation on the board could improve strategic oversight of competitiveness, particularly for products or services addressing female consumers. The company subsequently increased its disclosure around how gender is considered in the nomination process and later appointed a female director. The new director’s background brings fresh expertise to the board in a sector that is expected to become a key area of strategic focus for the company.

The corporate bond market in Japan is distinct from the broader Asian region, with only around 450 bond issuers. In addition, the rating distribution is skewed as there is no high-yield bond market. For Japanese credit research, our credit team takes an approach of analyzing and incorporating ESG factors into each stage of the investment decision-making process: (1) screening to identify material ESG issues and identify engagement targets, (2) ESG integration into traditional credit analysis, (3) dialogue and engagement with issuers, and (4) investment.

Taking into account the characteristics of the bond market in Japan and the strength and opportunities for Japanese corporates, the credit team has focused on ESG engagement activities.

Engagement in Japan

In Japan, a culture of investor engagement on ESG issues is still in its infancy. However, we believe that the Japanese corporate sector shares an implicit cultural understanding about how companies serve a broad range of stakeholders, known as “sanpo yoshi” (win for the seller, win for the buyer, win for society). Therefore, our engagement program aims to encourage companies to make this understanding explicit for a global investor audience through the disclosure of progress and setting quantitative targets.

In preparation for an engagement session, both our credit and ESG teams conduct in-depth reviews of a company’s disclosure practices in English and Japanese. This process helps us to understand the degree to which a company is building sustainability into its business strategy, and gives us insight into the quality of company data in light of potential translation issues. It can also allow us to objectively identify best performers and laggards, as well as define ESG disclosure needs. Our discussions with companies often candidly cover pain points around gathering and disclosing data, third-party ESG research, and getting internal stakeholder buy-in for disclosure. Encouragingly, after building relationships through multiple meetings, companies we engage with are setting concrete targets on ESG issues and disclosing their progress toward these goals.  

Enhancing corporate value creation in Japanese utilities

There are 11 major electric power companies in Japan, and their bonds make up around 15% of the total amount of Japanese corporate bonds outstanding.⁹ Consequently, this sector comprises a significant component of Japanese core fixed-income allocations for global investors. By the same token, efforts to increase the corporate value of electric power companies (EPCOs) may have an outsized impact on performance results.

Our local credit team has been a multi-year stakeholder in most of the 11 major utilities in Japan. In our frequent communication with these companies, we realize that the central challenge they face concerns maintaining a stable energy supply with the need to move toward a lower-carbon future. This is an enormous task, and EPCOs are focusing much of their efforts on developing technologies to drive emission reduction in light of the suspension of nuclear power in the post-Fukushima era.

In the first place, Japan is heavily dependent on energy imports. In terms of energy self-sufficiency (calculated by dividing the total primary energy supply of a country by its energy production), Japan is only 8% self-sufficient—substantially lower than other developed markets, including France (56%), the United Kingdom (66%), China (84%), the United States (92%), and Canada (174%). In addition, Japan’s habitable residential area, at 27.3%, is both lower than other countries and more concentrated in coastal cities, where the physical hazards of climate risk are relatively higher.¹⁰

In our bilateral engagement discussions with these companies, we appreciate these foundational issues and therefore find a readier audience for sharing our views on where global investors are moving in the pursuit of a low-carbon economy, our own experience of addressing carbon risk in our portfolios, and our work to raise Japanese companies’ awareness of the TCFD. Significantly, all 11 EPCOs support the TCFD, and we consult with them regarding the industry’s collective carbon target while encouraging individual EPCOs to set their own carbon targets.

Our experience has taught us that investors need to consider the local context when they think about a global climate imperative like the low-carbon transition. Furthermore, we believe a collaborative approach is essential to encourage Japanese EPCOs’ low-carbon adaptation, because such adaptation doesn’t allow for simple answers.

Renewables, for example, have some constitutive challenges in Japan that are also important to understand for engagement on ESG issues to have the most impact. In the case of offshore wind, building capacity around Japan can be a more expensive and risky project than building off the coast of other countries where shallow waters and lower seismic activity make offshore wind projects more economically viable. In the case of geothermal power, higher seismicity also complicates the picture, as does the convergence of geothermal sites with the relatively small proportion of habitable residential areas. At the same time, the restart of nuclear plants has required that rigorous safety measures be put in place in the post-Fukushima era. Understanding these issues is a requirement for being able to steadily and constructively build support among multiple stakeholders, a necessary condition for driving progress toward a managed transition that makes sense in the local context.

Against a backdrop of sometimes conflicting and evolving paradigms for issuing and investing sustainably in Asian assets, we believe that stakeholders must conduct careful and collaborative due diligence to avoid muddled results. From the point of a bond’s issuance to the implementation of sustainable investment objectives in relation to that bond, stakeholders need to develop rigorous processes to evaluate each issuer’s ESG profile. We believe that active research and engagement is vital to identifying true areas of ESG risk and opportunity, developing cogent strategies for mitigating or capturing these factors, and strategically integrating these issues into our portfolios.

In our view, corporate engagement can go a long way toward fulfilling these objectives, particularly if it’s conducted with sensitivity to local conditions without losing sight of more global sustainability objectives. But for it to be most effective, we believe engagement needs to emphasize developing a long-term partnership to drive more sustainable business practices. 

1 Global Sustainable Investment Alliance, 2018 Global Sustainable Investment Review. 2 HSBC Green Bond Market Overview 2019, March 22, 2019; Climate Bond Initiative, “Green Bonds: The State of the Market 2018,” p 3, available at https://www.climatebonds.net/files/reports/cbi_gbm_final_032019_web.pdf. 3 J.P. Morgan Asia Credit Index, data as of September 30, 2019. We note that the ESG version of this index, the JESG JACI, which narrows the JACI investment universe by around a quarter based on ESG performance metrics, has delivered near-identical returns to the JACI since December 31, 2012, based on JP Morgan’s back-testing: “Introducing the JESG JACI,” November 27, 2019. 4 “ESG Integration in Asia Pacific: Markets, Practices, and Data,” CFA Institute and Principles for Responsible Investment, May 30, 2019. 5 United Nations World Population Prospects 2019. 6 Brittanica.com. 7 “Asia’s Ageing Challenge,” The Economist Intelligence Unit, July 23, 2018. 8 See https://www.boarddiversityhk.org/, as of December 11, 2019. 9 Data based on the Nomura Bond Performance Index (BPI), as of September 30, 2019. The Nomura BPI reflects the performance of the entire secondary market for publicly offered, yen-denominated bonds issued in Japan. 10 Japan Institute of Country-ology and Engineering, http://www.jice.or.jp/knowledge/japan/commentary06, as of December 12, 2019. Countries such as the United Kingdom, France, and Germany, at 84.6%, 74.5%, and 66.7%, respectively, have much larger habitable residential areas, and are generally spread over a more diverse and higher-elevation topography relative to Japan.