Environmental, social and governance (ESG) factors are value drivers that help us identify current and future winners for our investment portfolios. Demand from investors for investment strategies and products that emphasise ESG integration continues to grow rapidly. Within the fixed income universe, the high yield segment is in a unique situation, as many issuers are not publicly owned companies and a majority of issuers’ capital structure consists of debt instruments – a somewhat different combination from what we see in equity markets.
The High Yield Corporate Bond team at NN Investment Partners (NN IP) believes that ESG integration makes good business sense. The team’s investment approach is based on the conviction that ESG factors have the potential to drive spread volatility and default risk, two of the most crucial aspects of high yield investing. ESG considerations have formed part of the team’s fundamental credit analysis since the early 2000s.
ESG criteria are integrated throughout the investment process for 66% of NN IP’s assets under management, as of 30 June 2019. Our stringent approach means that their integration is demonstrable and documented in a consistent way. This article, part of a series in which we look at the role that ESG factors play in our range of investment strategies, features three key members of our High Yield team. Sebastiaan Reinders, global head of high yield, along with Jeroen Heemskerk, lead portfolio manager for European high yield, and J.D. Rieber, director of research for US credit, discuss how the team applies ESG integration when investing in high yield debt.
ESG considerations have a very high profile in the market right now. How have high yield issuers adjusted to investor demands for disclosure and higher standards?
While demand from investors has been rapidly increasing, the response from high yield bond issuers has so far been muted. Underwriters are beginning to slowly push issuers to provide better ESG disclosure in their offering memoranda, but reporting on ESG-related performance indicators still lags behind other market segments.
Most reporting is done on an opportunistic basis – bond issuers that find themselves contributing positively to environmental or social goals, often because of the nature of their business, are more keen to highlight those positives when presenting themselves to investors.
We do, however, see an increase in the number of companies that are reporting on ESG topics such as how they address the United Nations Sustainable Development Goals (SDGs), or on their carbon emissions and recycling efforts. This trend is still in an early stage, and we expect it to gain strength in the years to come.
How do we incorporate ESG considerations into corporate credit analysis in HY space? Are there aspects that are particularly important or relevant in your segment?
The Global High Yield team incorporates ESG factors into every step of its investment process, including our fundamental credit analysis. ESG considerations have been part of our credit analysis since the inception of HY investing at NN IP, and with increased availability of data we have been able to increase the level of granularity.
When we assess an issuer’s credit strength and outlook, we use its current and expected ESG profile as one of the four building blocks, alongside management and strategy, business risk and financials. By doing so, we ensure that ESG is fully integrated in our fundamental credit analysis.
Although we incorporate all aspects of an issuer’s ESG profile into our internal credit assessment, we find governance particularly relevant for our analysis. Less than half of the companies in our investment universe have public shareholders. We believe good governance is crucial to mitigating the risks for bondholders that might arise from less disclosure and lower transparency from privately owned companies.
More generically, ESG considerations are very relevant for our relative value discussions. We often encounter controversies that are already being resolved and should be taken into consideration when assessing the issuer’s expected future creditworthiness. Given that much of the data from external providers is backward-looking, we typically make our own forward-looking assessment based on our analysts’ insights, which emphasises the importance of not simply relying on external information.
“ESG considerations have been part of our credit analysis since the inception of HY investing at NN IP, and with increased availability of data we have been able to increase the level of granularity.”
How do you build up an investment case? Is there much ESG data available from external sources or do you have to carry out most of the analysis yourselves?
ESG data availability is indeed the biggest hurdle for many HY investors. We continuously work on improving the quality and the breadth of our ESG data. We use a number of external data providers to support our proprietary credit analysis and ESG assessment. Some of our data vendors are quite proficient at capturing slow-moving ESG characteristics, while others enable us to incorporate the day-to-day news flow.
In practice, due to the lack of available data, we can often add value by conducting ESG research ourselves, for example when interacting with management teams. We have also developed smart solutions to deal with data gaps, such as estimating missing ESG datapoints with machine-learning techniques. This is how we achieve full coverage of our investment universe on, for example, carbon emissions data.
Last but not least: in our conversations with management teams of invested companies we encourage them to “up their game” with regard to reporting and disclosure. In many of these small and private capital structures, our position as bondholders can significantly influence an issuer’s cost of capital, giving us substantial access to senior management.
“Different clients have different requirements, but most of them expect us to fully integrate ESG factors in the investment process.”
Are sustainability and ESG integration high on the agenda of your investors? What kind of requirements do your clients have when it comes to sustainability?
Sustainability has become crucially important to our clients, and we expect it to become even more so. Different clients have different requirements, but most of them expect us to fully integrate ESG factors in the investment process. We often receive “responsible investment questionnaires” that we use to explain how ESG factors affect our clients’ portfolios. Every request for proposal also includes questions about responsible investing. For some clients, we create tailor-made exclusion lists that go beyond NN IP’s exclusions. For selected products, we provide clients with a monthly overview of where and how ESG factors have had a meaningful impact on our investment decisions.
Slowly but surely, we are seeing more and more attention being paid to sustainable investing as well. We maintain an active dialogue with our clients to determine which ESG approach suits them best.
Which sectors in HY space are frontrunners in terms of ESG considerations? And which need to make more progress?
We have developed a materiality framework that identifies the material ESG drivers per sector. Using this as a starting point, we can distinguish the factors that could materially influence the financial performance of a company, in terms of either risk or return. This lets us capture downside risks as well as opportunities. Among financial companies, for example, governance is one of the primary considerations. Environmental issues have greater emphasis for sectors like energy, chemicals and mining, while social issues can be particularly relevant for healthcare and pharmaceuticals.
Within the HY universe, it may seem obvious that many energy companies, such as those involved in activities related to shale gas, have room to improve. At the same time, more renewable energy companies are issuing bonds, which we have often found attractive investments – one reason being their regulatory tailwinds. But when really speaking of frontrunners: we see a good amount of innovation in healthcare and pharma, as well as in packaging, where themes like the use of plastic and recycling play a big role.
What have we learned from integrating ESG factors? What improvements have we seen in how companies incorporate and manage ESG considerations? And what do we expect for the future?
Data quality and availability remain very important focus areas for us. Together with our in-house Responsible Investing team and data scientists, we are working hard to keep improving our databases.
Among high yield companies in particular, we see increased communication related to the UN SDGs. In consultation with the Responsible Investing team, we have developed an internal framework, based on NN IP’s materiality matrix, that allows us to assess the impact of the companies in our portfolios on each of the 17 SDGs.
Do you also incorporate engagement efforts? How does this work in the HY debt arena?
“Engagement” means many things to many people. We recognise three different ways of interacting with companies on ESG topics. Firstly, our investment team interacts with the management teams on material or potentially material items for our investment case. We incorporate this dialogue into our investment process as we would any other information-gathering and fact-finding needed to understand the performance potential and risks involved in an investment case. We are an active investor and know all of the companies in our portfolio, and we often meet or speak with companies during roadshows for a new issue, during earnings season or at conferences.
For example, we might ask the management team of a consumer goods company to clarify the potential use of palm oil in their product, or a pharmaceutical company about their progress on institutionalising a pricing committee to prevent excessive price increases for medicines from recurring.
The second two ways of engagement involve a company-wide approach, whereby we work closely with our colleagues from the Responsible Investing team and sometimes with external parties. Together, we embark on what is usually a multi-year engagement trajectory involving milestones and targets. As a bond investor we don’t have the voting rights that equity investors have, but we can still engage in the same way equity investors do.
One company-wide approach is controversy engagement, which focuses on companies that severely and structurally breach NN IP’s norms-based criteria in the areas of governance, human rights, labour, the environment, and bribery and corruption. This type of engagement is initiated and assessed by the Controversy and Engagement Council.
The other method is thematic engagement, which focuses on different themes with a material impact on society, and where we believe we can achieve beneficial change. We also look at the material risks as defined by the World Economic Forum and the objectives as defined by the UN SDGs. By using these parameters, we can narrow our focus to ensure we have an impact.
“HY companies should have a strong interest in understanding what bond investors consider to be important ESG matters, because that would allow them to reduce their cost of capital.”
In conclusion, what should investors look out for when aiming to invest responsibly in HY?
Investors should be aware that high yield issuers are generally rated as such for good reason – they do carry a higher risk. They may be small companies, or they may be working through financially challenging times. As such, their management teams’ priorities often lie in improving the financial profile, so they might be less focused on ESG reporting or spending capital on innovative projects that can help the environmental footprint. However, given these risk profiles, it is all the more important to realise that ESG integration can help identify risks and allows you to make a better-informed decision on whether to invest.
As a final note, we should also reiterate that as leverage among HY companies is typically on the high side, a large majority of the capital structure is made up of debt instruments. Therefore, those companies should theoretically have a strong interest in understanding what bond investors consider to be important ESG matters, because that would allow them to reduce their cost of capital. We expect both investors and companies to keep increasing their interest in ESG, and NN IP will be at the forefront.
Sebastiaan Reinders, Global Head Of High Yield & Jeroen Heemskerk, Lead Portfolio Manager European High Yield NN Investment Partners (NN IP)