Federated's approach to incorporating ESG into the credit analysis of corporate issuers focuses on three areas: data, materiality and engagement. These elements are the foundation for formulating a proprietary ESG rating for the issuer which is then added to the overall credit score of the issuer; the ESG score can either enhance or decrease the overall score and help determine if a particular issuer meets the credit quality criteria for a given portfolio. This integration of ESG data with fundamental quantitative metrics and other qualitative considerations allows a more robust understanding of the risks and opportunities within a security.
Data - Proprietary Dashboards are used to evaluate issuer ESG exposure and momentum. Our ESG Dashboard provides a concise digest of ESG data, incorporating research from 10 leading providers including Sustainalytics, MSCI, Trucost, Bloomberg, ISS and CDP, and it includes EOS at Federated Hermes ("EOS") engagement and stewardship information. A valuable component of the Dashboard is the QESG score, a proprietary ranking applied to over 12,000 global securities created by Hermes over a decade ago. The score captures how well a company manages ESG risk, versus its peers as well as ESG rating momentum. Investment teams incorporate the QESG rating, both the overall composite QESG score as well as individual E, S, and G pillar scores, to go deeper into a particular E, S, or G risk which may be increasing or decreasing in its materiality to the company.
In addition to the ESG Dashboard, investment teams have access to multiple portfolio-level tools for a holistic ESG perspective. Our Carbon Tool enables investment teams to identify carbon risks in their portfolios and specific issuers that are or might become more exposed to carbon risks in the future. Another key tool is the Portfolio Snapshot which retains differentiated engagement analytics. The tool incorporates engagement activity as a percentage of AUM and also by ESG theme as well as progress achieved towards engagement objectives for that company. This tool identifies a portfolio's carbon emission outliers for Scope 1, 2, and 3 emissions relative to its benchmark and industry peers.
Materiality - Research is focused on financially material ESG risks and opportunities in each industry. Identifying financially material factors requires both fundamental research and external sources such as sell-side research and NRA reports such as Moody's, Fitch and S&P. In 2018 Federated joined the Sustainability Accounting Standards Board (SASB). SASB has developed a complete set of standards for 77 industries, focusing on ESG and sustainability risks that are financially material to each industry sector. Investment teams have access to SASB materiality maps through a centralized ESG hub that houses SASB materiality matrices, proprietary ESG portfolio tools, ESG third-party data and EOS corporate engagement insights.
Engagement - Investment teams have access to unique ESG insights about a specific issuer through EOS dedicated engagers. These corporate engagement specialists have deep knowledge of industry sectors, the companies they cover, and material ESG priorities, providing meaningful insight into an issuer's willingness to managing their ESG risks within the context of an enterprise's long-term strategic plan. This perspective on long-term ESG risks can impact an investment team's assessment of bond valuations. Direct engagement with issuers is not only important to obtain additional insights into a company's ESG practices, it can also serve as a mechanism to improve issuer's ESG profiles and thereby reduce risks over the longer term.
External sources of data as described above for identifying ESG risks are not always as available or are limited for certain asset classes. When this is the case, as it is for the high yield bond market, one of our firm's largest franchises, our investment team developed a proprietary framework for identifying potential ESG risks and opportunities. Our high yield strategy applies a bottom-up process, focusing on strong operating companies that generate free cash flow in stable and predictable businesses. Our process includes: focus on franchise value, industry profile, competitive profile, strength of management, i.e.. governance, forward-looking view of company financials and a belief that the market is more efficient at pricing high-yield credit risk than rating agencies, from whom we may hold a fundamentally different view of quality.
Our high yield investment team has developed a proprietary ESG research framework for incorporating ESG considerations across all high yield securities:
- Proprietary ratings process - Analysts identify sector-specific risks that companies face within environmental and social dimensions via research sources such as SASB materiality map; then the governance structure is evaluated to determine whether it is appropriate and capable of mitigating these risks. Sector level risk factors can include labor market indicators, human capital development, privacy issues, supply chain concerns, diversity and carbon footprint . Analysts comment specifically on the level of risk and how management teams are addressing those risks.
- Risk - Analysts are expected to formulate an ESG rating and comment on relative value risk/reward.
- Bondholder Protections - As part of our governance assessment, analysts vigilantly monitor bondholder protections. While our analysts have always engaged with management teams to evaluate factors fundamentally impacting credit, ESG due diligence is viewed as a natural extension of their primary debtholder stewardship research.
Marrying the team's proprietary credit analysis assessment with ESG ratings allows the team to identify low or poor ESG companies with low credit analytics and identify business risks that could cause the spreads to widen. Companies are then siloed by credit analytics and by the issuer's ESG pillar components to scrutinize why particular companies are scoring poorly. A low score prompts a discussion about the risks inherent from ESG metrics and the analyst's views about the trajectory of the rating.