Editorial note: This piece is sponsored by T. Rowe Price
Integrating environmental, social and corporate governance (ESG) information into high yield strategies can augment risk analysis, although there are challenges in finding information about private sector issuers.
ESG data can be used to analyse holdings both top down and bottom up - to avoid concentrations of individual or collective ESG risks, and to analyse individual issuers for their performance. Commonly, governance has been seen as the strongest risk when it comes to credit risk in general, and high yield specifically, but as environmental data and data relating to carbon emission intensity and other metrics related to climate change has improved, that has impacted on analysis in the high yield space.
Portfolio managers of high yield credit strategies have told FS Sustainability that integration of material ESG considerations are necessary in credit portfolios because of the asymmetrical risks of the asset class, and the risk of default.
A 2018 report by MSCI found that high yield issuers with high ESG ratings "tended to have tighter credit spreads, outperforming those with lower ratings, especially during market turbulence." MSCI applied its ESG Ratings to companies in the Bloomberg Barclays Global High Yield Index and found that the overall ESG score had a stronger correlation than individual ESG-pillar scores, "with the exception of the [high yield] governance pillar, likely due to the relevance of ESG key issues related to each specific industry."
Overall, the report found that well-managed companies tend to be more aligned with bondholder interests, and corporate transparency keeps bondholders better informed of exposure and management of risk, of particular relevance given the complexity and opacity in the high yield market.
Engagement in the high yield credit space is used to gain clarity on an issuer in general, particularly in private companies, and is also being used by fund managers to learn additional information on ESG matters. Credit managers, of course, lack the tool of the proxy vote that public equity owners have, but the impact of material ESG information goes into the calculation of spreads, which ultimately impacts on overall costs of capital.
Q&A with Michael Della Vedova, European high yield portfolio manager/analyst in the fixed income division at T. Rowe Price.
Q: How does ESG integrate into a high yield credit strategy?
A : We meet management teams and unpack the business plans and their financial modelling to determine how they plan to achieve what they seek to achieve. That naturally turns up potential ESG-related flags. An obvious one is governance. We don't want to be nervous on a company's reporting how management teams are going to communicate with us as an investor, because we want to be seen as a stakeholder. If that throws up a flag, it highlights board level issues, and by doing bottom up credit analysis and digging into the weeds, we can find that out.
Q: Is there a role for engagement when investing in high yield credit?
A: In high yield, you're dealing with companies that are sub-investment grade. They're companies that are financially weaker. The need for capital is greater. They're often more willing to listen to investors' concerns, if that means that allaying the concerns improves their access to capital. We always try to have engagement.
Q: How do you balance avoiding ESG risks while keeping a diversified portfolio?
A: You need to have a model to detect potential concentrations of risk that you might not see as you're doing bottom up research. I'll give you an easy example - if you were to look at the US high yield credit, it is between 14 and 15% energy-related. That means a large portion of your investable universe are energy bonds, and will instantly flag very heavily on the environmental side because of the carbon emissions intensity. That will flag our attention, but you need to be aware, because does that mean that exclude every energy-related issuer? You take it into account, because it could be 15% of investor base that you eliminate.
Q: How is climate risk priced into high yield?
A: If an energy utility with brown coal-based generation comes to market, not many people want to invest in it, because some, like us, will say no, we're not investing on environmental grounds. It comes back to pure supply/demand. Will cost them on the credit spread because the market will go look, I don't like this, there are fewer investors, less demand, they'll pay up to raise debt.
[Using the previous example], companies that already have debt outstanding, the market is also looking at them and saying the risk of refinancing is increasing, because there are fewer investors. That means the bond price goes down and the spread goes up. That's the other key issue.