By Claire Milhench
LONDON (Reuters) - Venezuela's crackdown on opponents of President Nicolas Maduro has made its government bonds too toxic for some investors but also raises a question for bond markets: why just Venezuela?
Screening sovereign debt for environmental, social and governance reasons -- known as ESG -- is in its infancy compared with well-established practice in equity investment.
This is especially so in emerging markets, where repressive governments or heavily polluting industries can still obtain international finance easily.
Less than a third of the total $700.2 billion in emerging market bond strategies tracked by research firm eVestment is said to be managed with environmental, social and governance considerations.
But pressure from pension fund clients is prompting fund managers and ratings agencies to think about how they can integrate such factors into their processes.
The turmoil in Venezuela, where more than 120 people have been killed in unrest since April, has already encouraged a number of funds to dump or reduce their Venezuela holdings.
Last week, Credit Suisse (SIX:CSGN) barred transactions involving certain Venezuelan bonds, insisting all its business with the country undergo a "reputation risk" review.
In June, Standard Life (LON:SLA) Investments said it was also avoiding exposure to Venezuela, noting it would not qualify for its emerging debt portfolios under socially responsible investment (SRI) principles.
"Venezuela highlights the increasing importance of incorporating SRI in asset classes where such decisions can have both a negative impact on the local population and reputational consequences for asset managers," it said.
Similarly, BlueBay Asset Management reduced its exposure to Venezuela bonds earlier this year, seeing a risk of an increase in Maduro's grip on power. Purely financially, the bet paid off as the bonds have lost almost 10 percent in value this year.
"What you are seeing in Venezuela is an ethical issue, which is increasingly becoming an investment issue," said My-Linh Ngo, head of ESG investment risk at BlueBay.
Ngo said that while ethical screening is less widely applied to bond investing than equities, one in three of her clients are now inquiring about it.
A dedicated environmental, social and governance screened bond fund that BlueBay launched in February has more than doubled in size to $92 million.
"There is more inherent risk in emerging and high yield (bonds) and your investment process should reflect that," she said.
SCREENING EMERGING MARKETS
Venezuela is being sold because the risk of default is rising as the economy deteriorates. Standard Life Investments said poor fundamentals, coupled with lower commodity prices, had made it wary of the sovereign's ability to sustain its debt payments.
BlueBay also flagged the growing risk of a hard line, Cuba-style repudiation of external debt.
But across emerging markets managers find it hard to apply ethical screening as the most profitable opportunities may be big corporate polluters with poor records on labor relations.
Assessing sovereign bonds against ethical frameworks is also tricky, especially in frontier markets where corruption can be common. For example, El Salvador, which tapped international bond markets earlier this year, ranks 95th out of 176 countries on Transparency International's Corruption Perceptions Index, just behind Colombia and Zambia.
"Of course we are concerned (about Venezuela) but there is a long list of EM countries who do not have these (ESG) things. Look at Egypt ... Look at Turkey -- what about civil rights? South Africa, Malaysia, the list goes on and on," said Shahzad Hasan, a portfolio manager at Allianz (DE:ALVG) Global Investors.
But more ESG bond investing does seem to be on the rise.
A 2016 study by Robeco and Erasmus University concluded that over a 25-year period, bonds from emerging markets with an improving political risk climate outperformed those where political risk had worsened.
"Long-term sustainability, in our belief, is synonymous with minimizing crisis or 'blow up' risk," Bryan Carter, head of emerging markets fixed income at BNP Paribas (PA:BNPP) Asset Management, said in a commentary.
Some ratings agencies are also starting to integrate ESG factors into credit scores, mindful of the policy risk related to the Paris Agreement on global warming.
Moody's says the credit quality of some $3.2 trillion in rated debt, including coal miners, car makers and utilities, will suffer from the transition to a low carbon economy, either near-term or in the next five years.
Denis Girault, head of emerging fixed income at Swiss-based asset manager UBP, believes eventually such considerations could become as important to funds as credit ratings.
"It will pick up momentum when it has an implication for the pricing," he said. "Bonds with a higher ESG rating will be in higher demand, therefore those companies will price tighter than their competition."