Breckinridge responded to the Securities and Exchange Commission’s proposal to amend Regulation S-K and rules for human capital management (HCM) disclosure.
- ESG analysis is a natural expansion of in-depth security research as the risks facing bond issuers and investors evolve.
- ESG analysis supports more in-depth risk assessment and long-term liability management for investment grade corporate, municipal and securitized bonds.
- Examples of risk insights revealed through ESG analysis that are discussed in this article illustrate its value for issuers and investors.
While most environmental, social and governance (ESG) investment options focus on equities rather than bonds,1 we believe that ESG analysis is a natural complement to the goals of fixed income investors and the investment process for investment grade (IG) securities across the corporate, municipal and securitized bond markets. At the same time, issuance through these markets can provide financing for initiatives to achieve desirable outcomes that align with ESG principles.
Equity investment is typically aimed more at total return or wealth-building (seeking upside potential), while fixed income investment typically centers around protecting capital against downside risks. Given that ESG analysis can offer additive insight to the underlying risks of an investment, we believe it is a strong support to bondholders’ objectives of risk mitigation and long-term liability management. In addition, ESG is well-aligned with the inherent properties of fixed income securities, which can have a long-term horizon depending on the maturity of the bonds held.
An allocation to fixed income often serves as a counterbalance to riskier securities. Long-term investment and credit trends – a demonstrated decline in the willingness to pay by certain U.S. municipalities, increasing leverage by corporations and evolving conditions in the securitized bond markets – give insight into how consideration of material ESG issues can be a solid ally in prudent credit selection.
- Fixed Income as a Counterbalance to Riskier Securities
One of the main roles of IG fixed income for investors – acting as a counterbalance to equities and other riskier assets – lends itself to ESG analysis. While traditional financial statements are valuable, they do not always tell the full story of a bond issuer. By analyzing extra financial factors as well, we believe bond investors are positioned to better understand borrowers, such as companies, local governments and securitized bond issuers, and mitigate evolving risks.
For example, in the fall of 2018, California signed SB100 into law. SB100 is a clean-energy bill that requires the state’s electricity to be emissions-free by 2045. California’s move galvanized others to follow in 2019, as a number of states debated or passed laws that impose strict emissions targets and materially alter how electricity will be generated (see Why Electric Bills Are Becoming Just As Complicated For The Utilities Themselves). Markets could eventually begin to look at greenhouse gas (GHG) emissions with more scrutiny than in the past; that is, the market could begin to price GHG risk higher, leading to bond price declines and increased credit risk for some issuers. Consideration of ESG issues, in this case carbon transition risk, could help to home in on potential threats that may be underpriced in the market.
- Fixed Income as a Long-Term Investment
Fixed income investors typically have a longer-term horizon, and we note that some borrowers issue 30-year or even 100-year bonds. Most IG bond investors are interested in capital preservation and steady, reliable income over the long term (see The Short-termism Debate Heats Up). The analysis of material ESG factors helps to identify issues that could materialize over the long term.
As examples, risks such as high local unemployment, educational inequality in a community or a lack of independent board membership in a corporation could cause minor disruption to credit spreads or ratings in the short term and could significantly hurt long-term fundamentals. Also signaling a long-term horizon, we note that big lenders such as Citigroup have developed risk-management frameworks that incorporate material environmental and social risks for project-related finance.2
Agency mortgage-related securities offered in the securitized market can offer long maturity schedules that fit well with a bond investor’s time horizon, without exposing the investor to the credit risk associated with long-dated corporate bonds. A comprehensive assessment of the impact climate-related risks pose to the prepayment speeds of agency mortgage-backed securities (MBS), provides additional insight into the risk return tradeoff of these securities. At the same time, these securities can provide financing to build much needed single- or multi-family housing for low- and middle-income families.
- IG Credit Deterioration Is Typically Slow …
IG corporate and municipal annual default rates are historically near zero, and the credit risks for IG bonds can take many years to manifest. This “slow burn” of high-quality credit deterioration lends itself to analysis that is focused on long-term, sustainable credit performance. Furthermore, ESG analysis often reveals management priorities; in our opinion, a management team that prioritizes ESG risks and takes advantage of sustainability to drive revenue growth is better positioned over the long term.
- … but Current IG Trends Require Diligence
While a focus on long-term trends is paramount for bondholders, we have noted that some conditions in corporate, municipal and securitized markets may accelerate deterioration for certain credits. These conditions require investors to closely analyze issuers, including underlying collateral for asset-backed securities (ABS), and to avoid becoming complacent. By shining a light on extra financial issues for borrowers, ESG analysis can help investors be more discerning in their credit selection.
For municipals, the “rules” of credit quality have been challenged by events in recent years. As Moody’s notes, “The once-comfortable aphorism that ‘munis don’t default’ is no longer credible.”3 Illinois was on the verge of being downgraded below IG, which would have been a first for a U.S. state, Declining willingness-to-pay in the market, questions of seniority and repayment surrounding Puerto Rico bonds, and growing pension debt across some U.S. states have increased the importance of in-depth municipal bond analysis. ESG analysis can offer insight into the quality of a municipality’s governance practices, including the commitment on behalf of its elected officials to meeting debt and pension obligations.
In another example, reputational risk is a growing credit concern in the not-for-profit healthcare sector. As hospital systems merge and become more “corporate” in terms of the size and scope of their service offerings, public perception of these entities is increasingly important to their long-term success. A healthcare provider with an effective leadership team and an engaged board of directors is often better equipped to handle governance risks more commonly associated with a large corporation. Instances of reputational risk in the not-for-profit hospital space include the 2019 controversy over survival statistics for the heart transplant program at Newark Beth Israel Medical Center, and numerous ransomware incidents in which attackers threaten hospital systems with release of sensitive patient records.
On the corporate side, acknowledging some recent efforts to pay down debt, financial leverage4 is still notably above its long-term average. In addition, if U.S. economic growth slows more than expected, leverage could go even higher. While IG defaults are typically negligible, the BBB corporate market is half of the total market – meaning the average IG borrower has less cushion than in the past – which could drive greater ratings transition from IG into speculative grade during an economic downturn. While we acknowledge more large companies are making progress on ESG goals and performance, high leverage may constrain necessary long-term capital expenditures and investment on sustainability related opportunities.
For ABS, the market is being challenged by an increase in subprime automotive delinquencies. A decline in underwriting standards may reflect inadequate incomes of the borrowers and a lack of income verification standards by the issuer. Credit and ESG analysis can help evaluate the quality of the bank’s lending practices, includes its focus on financial inclusion, a material ESG issue for the sector.
- High-Impact, Low-Probability Events
In addition to the merits listed above, ESG analysis can help mitigate the asymmetric return profile of fixed income investing. IG bond performance has an inherent asymmetry; upside potential from capital gains is typically limited, while downside risk in the event of default is significant. However, as mentioned, IG defaults are very “low probability,” as the IG default rate for municipals and corporates has been near zero.5 Ratings risk is also a concern, but higher-rated credits have historically exhibited strong ratings stability, per S&P. For the first time since the financial crisis, in 2018 the global default rate for structured finance fell below 2%, while the upgrade rate rose to a record high, according to S&P Global Ratings' annual analysis of defaults and rating transitions.
We think ESG analysis is a natural match for the “high-impact, low-probability” types of events that could lead to a decline in the credit quality of a security or a widening in an issuer’s credit spreads by helping investors uncover underpriced risks of borrowers. These events could include corporate governance scandals, major environmental disasters or burdensome legal fees.
The financial crisis, negative credit outcomes related to poor corporate governance and short-termism, have helped prompt growing demand for strategies that consider the relevance of extra financial factors. Ultimately, we continue to believe that integrating ESG analysis with traditional financial analysis can lead to improved long-term risk-adjusted returns in fixed income.
(John Bastoni, securitized trader, and Andrew Teras, senior vice president, also contributed to this article, which was originally published on October 4, 2018.)
 Of nearly 1900 ESG funds tracked by Bloomberg, 62 percent invest in equities versus only 15 percent that invest in fixed income. On an asset basis, bonds make up only 3 percent of the $491 billion invested in ESG funds. Source: Chasan, Emily. “How to Build a Sustainable Bond Portfolio.” Bloomberg, August 29, 2018.
 Citi Environmental and Social Policy Framework, April 2018.
 Moody’s Investors Service, June 2017.
 Barclays reports, US Investment Grade Corporate Update, November 2019 and December 2019.
 Diane Vazza and Nick W. Kraemer, “Default, Transition, and Recovery: 2017 Annual Global Corporate Default Study and Rating Transitions,” Standard & Poor’s, as of April 5, 2018. Lawrence Witte, Zev Gurwitz and Nicholas Castro, “Default, Transition, and Recovery: 2017 Annual U.S. Public Finance Default Study And Rating Transitions,” Standard & Poor’s, as of May 8, 2018.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions.
While Breckinridge believes the assessment of ESG criteria can improve overall credit risk analysis, there is no guarantee that integrating ESG analysis will provide improved risk-adjusted returns over any specific time period.
Some information has been taken directly from unaffiliated third-party sources. Breckinridge believes such information is reliable but does not guarantee its accuracy or completeness.
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