Case study: an emerging market quasi-sovereign issuer

Background to the investment case

ESG factors can be particularly important to credit quality in emerging markets (EM) fixed income. This particularly applies to quasi-sovereign issuers that are exposed to both sovereign and corporate risks. In this example, our proprietary assessment of ESG risks at a quasi-sovereign company allowed us to avoid an initial governance scandal and then opportunistically take advantage of the mispricing of the associated risk.

ESG factor which drove the investment decision

Before we assess the ESG risk of a corporate issuer, we leverage the expertise of our sovereign team to understand country-specific ESG risk factors, which comprise 40% of our country credit model, and include issues such as political stability and security, and corruption. These signals can remain weak even as broader macroeconomic indicators improve in a country. This understanding of sovereign risk can be important when assessing sovereign-owned corporate issuers, as credit or ESG risk factors are often obscured.

Due to its frequent issuance and significant weight in EM benchmarks, a sovereign-owned oil and gas company presented a unique case. Since 2011, the company’s credit profile suffered from government involvement in corporate decision making, which led to the use of the company’s balance sheet to subsidise the country’s fuel prices and ambitious infrastructure projects. Given our concerns about deteriorating credit metrics and corporate governance, in 2014 we were underweight the issuer relative to the benchmark. However, we maintained exposure to the country’s oil and gas sector by taking positions in other, more fairly valued, off-benchmark issuers.

In late 2014, the company was implicated in a corruption scandal. The scandal’s impact on the balance sheet caused the release of key financial disclosures to be postponed, causing significant volatility as it restricted the company’s market access and called into question the adequacy of its liquidity position. During the fourth quarter of 2014, we reviewed companies that had derivative exposure to the issuer and the scandal, and exited these positions to mitigate risk. At the same time, we felt that the issuer debt itself was excessively penalised by the market, and because of our confidence that the sovereign support would enable the company to navigate these challenges, we chose to take a benchmark weight exposure to the issuer.

We participated in a market call with the company in November 2014 to discuss the delayed financials and met management in January 2015 to understand plans for addressing governance deficiencies. We were encouraged by planned steps to improve corporate governance. Senior management was replaced in February 2015, which led to more transparent hiring practices designed to ensure professional and ethical qualifications of candidates, improved internal financial controls, as well as clearer procurement protocols.

We participated in further market calls with senior management and monitored the implementation of fundamental governance enhancements. As the company regained market access, we met again with management in May 2015 and were able to opportunistically take advantage of weak bond prices and increase our position.

Even with the improved governance structures, political risks remain, but management has stayed committed to reducing debt and focusing on cost and capital discipline, as well as improving transparency by making its fuel pricing policy more market-driven and introducing private partners to prevent a policy rollback by future administrations. Our consistent engagement with management over the years allowed us to take a more informed view on the company’s governance standards and their impact on fundamental performance.

Market implications

Leverage grew sharply through 2013 and 2014 due to sovereign-influenced management decisions. Improved governance was a key factor in driving better credit metrics in mid-2015 and beyond and our engagement allowed us to opportunistically increase positioning ahead of a long-term improvement trends.

Key takeaways

Because sovereign and corporate ESG factors can interact when analysing credit quality in emerging markets fixed income, engagement can bring additional insight to avoid scandal and potentially even take advantage of the mispricing of the associated risk. These sometimes obscure risks could mean suppliers/downstream players unknowingly have exposure and markets may overreact or belatedly recognise ESG issues, which can create opportunities for engaged investors.