ESG research goes beyond the balance sheet to incorporate additional, extra-financial risk factors into traditional credit analysis. We believe our approach to systematically integrating ESG factors in our research process is a differentiator.
A Closer Look at the Materiality of ESG Analysis
The relevancy of any ESG factor varies across corporate, municipal or securitized bonds, with sector-specific characteristics influencing materiality. Breckinridge analysts integrate third-party data and their own analysis of financial and non-financial factors to develop forward-looking views.
To evaluate the ESG risks of corporate bonds, we utilize proprietary, sector-specific frameworks based on materiality and comparables analysis supported by data and research from third-party sources such as the Sustainability Accounting Standards Board (SASB)1 and Sustainalytics. Our analysts also review corporate sustainability reports, ESG reporting and conduct direct engagement with issuers. For municipal bonds, we employ 10 proprietary sector-specific frameworks, aggregating material data from various sources such as the U.S. Census, the EPA, the CDC and others.
Corporate Bonds
Recognizing the costs of unsustainable business practices
In the corporate world, event risk and credit distress can unfold in an instant. Breckinridge closely examines corporate bond issuers seeking to uncover the potential for sudden deterioration.
Regulatory and environmental risk.
Long-term investors should be cognizant of externalities posed by the operations of companies in which they invest. Market reactions to scandals and catastrophes—as well as regulations across a range of issues from carbon emission standards to privacy laws—show that long-ignored activity that affects other parties may negatively affect companies and their investors.
Controversy risk.
Class-action lawsuits and workplace controversies can occur when corporations fail to respect fair labor practices, supply chains and the interests of other stakeholders. The consequences can be serious for an issuer’s creditworthiness and bond prices. By contrast, some of the best performers seize opportunities to engage their employees, support and monitor their suppliers, and invest in human capital—including diversity, equity and inclusion (DEI)—as well as their communities.
Management risk.
Excessive executive pay and accounting gimmickry are often signs of poor oversight. Well-governed organizations follow sound practices such as independent board representations and transparent disclosure of both financial and material non-financial data, including ESG performance factors.
ESG research integrated with fundamental analysis helps us assess the price of a bond and the reliability of a bond’s future cash flows. We have found that corporate policies and practices predicated on effective ESG behaviors can enhance a corporation’s long-term viability through lower costs, lower waste and greater efficiencies.
CAN A CARBON-INTENSIVE BUSINESS STILL BE “GREEN”?
Transportation and delivery companies are carbon-heavy and a blunt investment screen might exclude them from consideration. The sector requires a deeper look, as it provides an essential service within a global economy reliant on e-commerce.
Additional analysis may reveal strong sustainability practices such as above-average fleet efficiency, robust initiatives to cut carbon emissions and superior disclosure on climate risk.
Sustainable credit analysis can identify best-in-class performers by measuring these practices against peers and industry standards.
Corporate Equities
We view sustainability risks and opportunities for corporate equities from the same financial materiality perspective that we apply to bonds. All companies that issue equity securities that we consider to be eligible investments for our High Quality Dividend and Sustainable High Quality Dividend Strategy are rated by our analysts within our ESG ratings framework.2
Breckinridge’s Sustainable High Quality Dividend Strategy selectively invests in eligible companies with above-average ESG profiles as determined by our analysts.
Equity shareholders are entitled to vote by proxy on issues that impact a company's financials, including proposals related to ESG concerns. Investors in our High Quality Dividend Strategy and the Sustainable High Quality Dividend Strategy are entitled to proxy votes because they own the shares of stocks in their separate accounts managed by Breckinridge.
Clients may choose to vote their own proxies or delegate proxy voting authority to Breckinridge. We have engaged with a proxy advisory service in the administration of proxy voting.
Municipal Bonds
Identifying climate risk and outlier social and governance risks; assessing use-of-proceeds
ESG analysis can provide investors with insights into issuers’ climate risk exposure and enables the exploration of outlier social and governance factors in a systematic way. The approach helps us price credit risk.
Climate change poses distinct risks and opportunities for issuers, depending on geography, the built environment, and the local economy. Risks include exposure to rising seas, heat stress, and increasing frequency of powerful storms. Opportunities include job market exposure to emerging clean technologies and forward-looking land use planning or building codes. Climate-induced credit-rating downgrades remain infrequent. However, they are likely to become more common in the future.
Consistent assessment of social and governance characteristics can help highlight outliers. An impoverished and racially segregated school district may exhibit surprisingly strong test scores. An affluent city may have an unexpectedly high degree of political polarization on its city council or obstinately refuse to consider a valuable affordable housing strategy. These kinds of factors are rarely traceable to rating agency downgrades and slowly ripen into material credit risk. However, in our view, factors like these can be relevant, in extremis.
Assessing each bond issue’s use-of-proceeds for its societal relevance is also important to gauging credit risk. Traditionally, projects that are highly essential to the communities they serve are resilient through credit cycles. Strong community support is a plus for municipal investors.
The most significant period of municipal distress occurred in the Depression-era. During that time, bonds issued for school construction and water and sewer systems had the lowest default rates.[3]
Securitized Bonds
Considering climate risk in mortgage-backed security analysis
Assessing the impact of climate-related risks to prepayment speeds of agency mortgage-backed securities (MBS) may provide insight into their risk/reward profile.
Breckinridge believes that looking beyond traditional data and analysis is a critical part of robust research. Including climate-related risk analysis in MBS research is additive to our evaluation of material fundamental and technical financial risk factors when analyzing agency MBS.
Assessing MBS Prepayment Speeds Following Natural Disasters
To better understand how climate risk can influence prepayment risk in MBS, the Breckinridge team analyzed the buyout policies of government-sponsored entities after environmental disasters, such as the hurricanes that hit the states of Florida and Texas in 2017. The team researched the effect that these events historically had on mortgage prepayment speeds. Breckinridge compared prepayment speeds six to twelve months after the occurrence of a natural disaster in various geographic regions against national averages. The research isolated the effect of natural disaster-related buyouts on prepayment speeds.
[1] SASB is the Sustainability Accounting Standards Board, a nonprofit publishes sustainability standards for seventy-seven industries.
[2] The ESG ratings framework is the same used for bond research. These ratings are leveraged for eligible equity securities.
[3] Municipal Bonds: A Century of Experience, Albert Hillhouse, 1936.