Environmental, social and governance (ESG) considerations are growing in importance across asset classes, but we believe that they have a particularly significant role to play in high yield investing. Properly evaluating a company’s ESG footprint can be key to assessing its credit quality, ultimately aiding investment decision-making. In an investment universe such as high yield that is dominated by private companies, ESG analysis can mitigate some of the risks for bondholders, stemming from lower disclosure and transparency standards. And while it is common to assume that shareholders enjoy more scope for engagement than bondholders, we argue that, as providers of new capital, bondholders may have more influence than they think.
These and other issues were addressed at a recent Neuberger Berman Roundtable Discussion that brought together experts from portfolio management, ESG analysis, wealth management, the United Nations-supported Principals for Responsible Investing (PRI) and academia.
To mark the launch of Neuberger Berman’s Global High Yield Sustainable Action Fund, we brought together five panellists to discuss the state of play in environmental, social and governance (ESG) investing in credit markets.
- Carmen Nuzzo, Head of Fixed Income, responsible for the ESG in Credit Risk and Ratings Initiative, UN-supported Principles for Responsible Investment (PRI)
- Chris Kocinski, Senior Portfolio Manager, Non-Investment Grade, Neuberger Berman
- Robert G Eccles, Professor of Management Practice at the Saïd Business School, University of Oxford
- James Purcell, Group Head of ESG, Sustainable and Impact Investing, Quintet Private Bank
- Jonathan Bailey, Head of ESG Investing, Neuberger Berman
Here are some key extracts from their conversation.
Does a better ESG profile mean a lower probability of default?
The panellists agreed that, while it is important to put the emphasis on ESG factors that are material and relevant to particular issuers, once we do, there is clear evidence that these factors have an impact on bonds’ performance and probability of default—and that this year’s coronavirus crisis has made the link clearer and more explicit.
It is now more obvious that this is a question of survival as much as it is a question of ethics, argued Carmen Nuzzo, Head of Fixed Income and Senior Consultant on the Credit Ratings Initiative at Principles for Responsible Investment (PRI).
“Some companies will default simply because they are in sectors that are really badly affected by COVID-19, but others will default not because of the impact of the virus itself, but because of pre-existing problems that the virus has uncovered, problems that might have been tackled with better governance and more prudent financial balance sheet management,” she said.
Jonathan Bailey, Neuberger Berman’s Head of ESG Investing, agreed that, rather than the coronavirus crisis suddenly creating all of our material social, workplace and supply chain-resilience problems, it has simply highlighted the consequences of pre-existing poor practice and poor disclosure.
“Without coronavirus, these weaknesses might have simply taken longer to play out, through higher staff turnover or declining customer engagement, or when a similar scale of disaster such as a hurricane or earthquake struck,” he suggested, adding that, in many ways, it has been a salutary experience. He described one large U.S. home hardware store where there was an initial disconnect between the reality reflected in social media commentary and sentiment analysis and the company’s public statements about protecting workers: once the material impact of those safety concerns in its workforce became clear, the firm quickly changed its policies, and that put it back in a good position to take advantage of the summer lockdown boom for its sector.
“If you have strong governance, if you don’t have unknown environmental risks on your balance sheet, if you don’t have problems with excessive staff turnover or litigation or reputational damage—that all reduces threats to your solvency as a firm,” reasoned James Purcell, Group Head of ESG, Sustainable and Impact Investing at Quintet Private Bank. “Ultimately, however, probability of default is about credit quality. A business can have a good ESG profile and still be a poor business.”
He pointed out that even a green bond can default, and that its credit rating refers to the credit quality of the issuer, not the ESG risks associated with the bond itself.
“Our own data suggests that there is a correlation between low NB ESG Scores and negative total return outliers,” said Chris Kocinski, a Non-Investment Grade Senior Portfolio Manager at Neuberger Berman. “And looking ahead, not least because natural resource companies are an important part of the high yield asset class, analysing how companies manage issues such as the transition away from fossil fuels is likely to be one of the key sources of alpha in high yield investing over the coming decade.”
But he added that integrating ESG factors into credit research does not imply replacing credit research with ESG factors. From an impact perspective, what we want to see is green bonds coming from issuers with the balance sheets and capital to support their initiatives, and responsible businesses taking a responsible approach to their finances.
“It’s difficult to have a sustained positive impact on the environment or society if you don’t have a sustainable balance sheet.”
Does a “junk” credit rating mean “junk” ESG practices?
Kocinski led Neuberger’s credit research organisation for many years and was heavily involved in building out the firm’s ESG capabilities and engagement platform, and he still serves on the firm’s ESG committee while managing dedicated sustainable high yield portfolios. He acknowledged that high yield issuers do tend to be slightly behind the curve on ESG, but added that they are increasingly interested in adopting ESG best-practice and engaging on ESG issues.
“I would argue that being a little behind the curve means that there’s more room to achieve positive change,” he said.
Nonetheless, the panellists agreed that smaller companies with fewer resources do not always have extensive reporting and disclosure among their top priorities.
“That doesn’t necessarily mean they’re any less sustainable, it just means you have to dig a bit deeper to get hold of the data you need in order to make sustainability and ESG judgements,” said Purcell.
“There’s clearly a difference depending on whether the issuer is a public or a private company,” added Robert Eccles, Professor of Management Practice at Oxford University’s Saïd Business School. “Given the sheer amount of dry powder that private equity firms have and the system-level impact private businesses and private markets are starting to exert, this black box really needs to be opened up. There are some General Partners doing a good job on transparency and disclosure, and they could be a source of leverage with private businesses, but real progress is likely to require more pressure from Limited Partners.”
Nuzzo added that anecdotal evidence suggests that, even when private companies and private equity managers gather the data and information on ESG factors, they do not always share it with their lenders.
Kocinski noted that close to 50% of high yield issuers are private companies, with some family owned but most in the hands of private equity. He confirmed that there is generally less disclosure from private issuers, but again noted improvements, and suggested that large capital providers like Neuberger Berman, with an extensive research capability, appear able to get more transparency.
Can rating agencies help with the data and disclosure challenge?
Talk of transparency and data quality led to discussion of the respective roles of traditional credit rating agencies and ESG data and rating providers.
“Personally, I don’t like references to ‘ESG ratings,’ and the reason is that when you work in the fixed income world the word ‘ratings’ evokes credit ratings,” said Nuzzo. “Credit ratings are based on the probability of default and, as has already been mentioned, while ESG factors may affect that probability, those ratings are not a guide to ESG credentials. The picture has become more confused over recent years, as credit rating agencies have started to products non-credit scores and we have begun to see some consolidation between the credit rating agencies and the ESG data providers.”
At the same time, Bailey observed, while ESG data providers have made important advances in the market, their methodologies and ratings were never designed for the high yield universe. Their business models simply don’t allow them to hire the number of analysts required to cover such a big universe of issuers in the required detail.
“One way around the limitations is to use alternative data sets—“Big Data”—to achieve more transparency and timeliness,” he suggested. “As with the home hardware retailer I mentioned earlier, it’s easy just to hear what the Investor Relations people are saying about workplace conditions or labor relations, but they are increasingly aware of what they are ‘supposed to say’ to us—it’s a good idea to trust but verify by looking at social media, websites like Glassdoor and other unmediated sentiment indicators.”
Can bondholders engage with companies like shareholders do?
Bailey added that another way around data limitations is to invest in a big credit research team and engage more seriously with high yield issuers—opening up a discussion of how much success bondholders can expect from engaged investing relative to shareholders.
Nuzzo observed that ESG integration in fixed income has been slower than in equities, partly due to a lag in relevant academic and market research but also partly due to a lack of a deep culture of engagement. She said that discussions with signatories about what had been most helpful for risk management during the coronavirus crisis revealed the importance of preparedness, but also clear communication and engagement around preparations put in place to respond to a crisis.
“Put simply, it’s a matter of knowing who to call during a crisis as opposed to having to figure out who to call—and that is not easy for bondholders, who often don’t have natural, ongoing points of reference within the companies they lend to,” she explained. “The fact that bond holders don’t have voting rights is often seen as a barrier to intervention and dialogue with management, particularly at high yield companies. It’s not easy to overcome that, because material ESG factors for a bondholder may be very different from, or even contradict, material factors for the equity investors who have more direct channels through which to engage.”
Eccles argued that the challenges of mutual engagement by bondholders and shareholders would likely be eased by increasingly codified standards for reporting and transparency, and pointed to a number of initiatives on the way, from guidance from the Sustainable Accounting Standards Board (SASB) through the Impact Management Project’s recent ‘statement of intent’ on comprehensive corporate reporting, to the European Union’s Non-Financial Reporting Directive.
“But really, I think that in many ways fixed income is a more powerful place for changing corporate behaviour than public equity,” he said. “When bonds are issued it should be a great time to convince borrowers to improve their ESG performance, when they can see it would be to their financial benefit.”
As a practitioner, Kocinski endorsed this view strongly.
“One thing that high yield company CFOs really care about is access to capital,” he said. “If you’re a large capital provider in the high yield market, therefore, you have no problems getting an audience with senior management. And if Neuberger Berman is telling, say, a utility-sector management team that we won’t continue to provide capital if they have no plan to transition to a sustainable asset base, that is pretty powerful.”
The message is yet more more powerful if an investor can come to an engagement with specific advice, he added, particularly when dealing with private companies. That means going beyond saying, ‘We want you to improve on ESG,’ and setting out specific goals, with a roadmap to achieve them, and committing to a long-term relationship to get there.
“That’s how lenders can really help to create positive change over time.”
Nuzzo agreed and noted that positive change is moving up the agenda of UNPRI signatories as they report their activities each year.
“The emphasis is clearly moving away from just pure risk assessment to something more impactful—whether that is pressing for better outcomes or for reduction of negative outcomes,” she told the panel. “And we expect our signatories to move in that direction.”
Kocinski said that he expected more high yield capital to tie its investment to bond-issuers’ progress on ESG goals. That is the premise of Neuberger Berman’s Global High Yield Sustainable Action Fund, he pointed out, and he thinks more examples will join it over the coming years.
Key Risks
Market Risk: The risk of a change in the value of a position as a result of underlying market factors, including among other things, the overall performance of companies and the market perception of the global economy.
Liquidity Risk: The risk that the portfolio may be unable to sell an investment readily at its fair market value. In extreme market conditions this can affect the portfolio’s ability to meet redemption requests upon demand.
Derivatives Risk: The portfolio is permitted to use certain types of financial derivative instruments (including certain complex instruments). This may increase the portfolio’s leverage significantly, which may cause large variations in the value of your share.
Credit Risk: The risk that bond issuers may fail to meet their interest repayments, or repay debt, resulting in temporary or permanent losses to the portfolio.
Interest Rate Risk: The risk of interest rate movements affecting the value of fixed-rate bonds.
Emerging Markets Risk: Emerging markets are likely to bear higher risk due to a possible lack of adequate financial, legal, social, political and economic structures, protection and stability as well as uncertain tax positions, which may lead to lower liquidity.
Counterparty Risk: The risk that a counterparty will not fulfil its payment obligation for a trade, contract or other transaction on the due date.
Operational Risk: The risk of direct or indirect loss resulting from inadequate or failed processes, people and systems, including those relating to the safekeeping of assets or from external events.
Currency Risk: Investors who subscribe in a currency other than the base currency of the portfolio are exposed to currency risk. Fluctuations in exchange rates may affect the return on investment. If the base currency of the portfolio is different from your local currency, then you should be aware that due to exchange rate fluctuations, the performance shown may increase or decrease if converted into your local currency.
Find out more about the Neuberger Berman Global high Yield Sustainable Action Fund.
