An important focus of PGIM Fixed Income’s sovereign research is on macroeconomic stability and debt sustainability. ESG issues feature prominently in this analysis and, in particular, the sovereign ratings process. In addition to a fundamental macroeconomic score that captures pertinent macroeconomic strengths and vulnerabilities, PGIM Fixed Income's sovereign ratings framework is also based upon a comprehensive assessment of qualitative aspects that guide policy making. These aspects include institutional strengths and weaknesses, potential governance issues, as well as social issues that could affect relevant macroeconomic variables.

We believe that any framework to assess ESG-related qualities needs to balance the objective of providing a comprehensive and consistent assessment with the challenges of data availability and reliability. Such constraints can quickly become binding when attempting to measure intangible variables, such as good governance or tolerance and social inclusiveness. At the same time, proper variable selection is critical to ensure that the rank sufficiently captures meaningful differences in ESG performance.

These considerations call for a systematic approach. PGIM Fixed Income has developed a proprietary index that provides an ESG-based ranking of countries, referred to as PGIM Fixed Income’s ESG Rank. The index methodology closely follows the approach underlying the construction of PGIM Fixed Income’s Fundamental Macro Rank (FMR). This rank compares macroeconomic strengths and vulnerabilities across different cohorts of countries.

For governance issues, we utilise the Worldwide Governance Indicators (WGI) which are widely recognised as a primary data source for governance issues. The World Bank collects these indices in collaboration with the Brookings Institution and the Natural Resource Governance Institute. Based on a large number of underlying variables, these indices provide country rankings for size categories, namely (i) voice and accountability; (ii) political stability and absence of violence; (iii) government effectiveness; (iv) regulatory quality; (v) rule of law; and (vi) control of corruption. Equally weighting these six sub-indices, we construct a headline index in order to arrive at country rank for governance issues.

At PGIM Fixed Income our analysts perform in-depth bottom up fundamental research with a view towards long term sustainability. The Principles of the UN Global Compact and the UN Sustainable Development Goals are a part of the lens through which we analyse all issuers and industries. We measure all our companies (especially those who operate with higher carbon footprints) in terms of their long run business plans and we try to determine if those plans are credible and achievable. We measure their progress against their plans to determine if management is reliable. When we think about long run sustainability, we take into consideration the carbon footprint and whether or not a company’s plans will ensure that they are a viable enterprise for the long run.

As part of the credit research process, PGIM Fixed Income analysts review publicly-available ESG concerns as well as those expressed by a third party provider (Sustainalytics). When we deem appropriate, analysts may engage with senior management of the issuer, requesting that they comment on any material ESG issues. The ESG concerns, as well as management's response to the comments (when applicable), are noted in our internal credit reports, which are made available to portfolio managers.

Governance is the most important ESG factor we consider for financials.  Business ethics and corruption, bribery, fraud, accounting standards, and board: Independence, Diversity, Transparency, Experience, Leadership are all important ESG factors that we consider most material within the financial industry.

At PGIM Fixed Income our analysts perform in-depth bottom up fundamental research with a view towards long term sustainability. The Principles of the UN Global Compact and the UN Sustainable Development Goals are a part of the lens through which we analyse all issuers and industries. We measure all our companies (especially those who operate with higher carbon footprints) in terms of their long run business plans and we try to determine if those plans are credible and achievable. We measure their progress against their plans to determine if management is reliable. When we think about long run sustainability, we take into consideration the carbon footprint and whether or not a company’s plans will ensure that they are a viable enterprise for the long run.

As part of the credit research process, PGIM Fixed Income analysts review publicly-available ESG concerns as well as those expressed by a third party provider (Sustainalytics). When we deem appropriate, analysts may engage with senior management of the issuer, requesting that they comment on any material ESG issues.

Climate risks and opportunities are one of the topics we address during engagements. For example, engagement on climate related issues is often discussed within our electric utilities and energy sectors.  Our utilities analysts monitor carbon emissions, fuel mix, power generation, carbon targets, renewable targets among other metrics disclosed by the companies as well as third party research from MSCI or Sustainalytics.  To the extent they have questions or need updates they engage with the issuers directly. 

The ESG concerns, as well as management's response to the comments (when applicable), are noted in our internal credit reports, which are made available to portfolio managers.

In securitised products we have been assigning securities internal ESG ratings for some time, but recently have evolved the ESG ratings framework to align to a firmwide methodology which has just been finalised.  The issues that inform the ESG ratings vary in consideration and can be sector specific.

Environmental considerations range from sponsors’ compliance with environmental regulation to broad sustainability issues. We were a lead investor in Fannie Mae’s first Green REMIC multifamily transaction, the proceeds of which were used to encourage apartment building owners to make energy and water-savings improvements; the outcome should be better quality housing with a lower environmental impact and positive cash flows.

Social considerations include lenders' origination and underwriting processes and servicing operations.  Analysts assess potential regulatory and reputational risks associated with predatory lending laws, disparate impact rulings, and known Consumer Financial Protection Bureau points of emphasis.

Regarding governance, analysts meet with management, audit, legal, and compliance departments to understand oversight of credit underwriting, origination, and servicing practices. Rigorous transaction documentation review helps mitigate shortfalls in the governance of the securitisations themselves.  Examples include identifying conflicts of interest between insiders (Trustees, Servicers, Rep and Warranty providers), identifying intercreditor issues (e.g. senior debt holder’s protection against junior class encroachment), assessing the document’s amendment process and transaction events of default, and ensuring dispute resolution mechanisms are documented and functional.

An important focus of PGIM Fixed Income’s sovereign research is on macroeconomic stability and debt sustainability. ESG issues feature prominently in this analysis and, in particular, the sovereign ratings process. In addition to a fundamental macroeconomic score that captures pertinent macroeconomic strengths and vulnerabilities, PGIM Fixed Income's sovereign ratings framework is also based upon a comprehensive assessment of qualitative aspects that guide policy making. These aspects include institutional strengths and weaknesses, potential governance issues, as well as social issues that could affect relevant macroeconomic variables.

We believe that any framework to assess ESG-related qualities needs to balance the objective of providing a comprehensive and consistent assessment with the challenges of data availability and reliability. Such constraints can quickly become binding when attempting to measure intangible variables, such as good governance or tolerance and social inclusiveness. At the same time, proper variable selection is critical to ensure that the rank sufficiently captures meaningful differences in ESG performance.

These considerations call for a systematic approach. PGIM Fixed Income has developed a proprietary index that provides an ESG-based ranking of countries, referred to as PGIM Fixed Income’s ESG Rank. The index methodology closely follows the approach underlying the construction of PGIM Fixed Income’s Fundamental Macro Rank (FMR). This rank compares macroeconomic strengths and vulnerabilities across different cohorts of countries

For governance issues, we utilise the Worldwide Governance Indicators (WGI) which are widely recognised as a primary data source for governance issues. The World Bank collects these indices in collaboration with the Brookings Institution and the Natural Resource Governance Institute. Based on a large number of underlying variables, these indices provide country rankings for size categories, namely (i) voice and accountability; (ii) political stability and absence of violence; (iii) government effectiveness; (iv) regulatory quality; (v) rule of law; and (vi) control of corruption. Equally weighting these six sub-indices, we construct a headline index in order to arrive at country rank for governance issues.

Our investment process begins with the senior investment team assessing the global market environment. This includes the review of any ESG issues by our credit research analysts or global economists. The majority of our ESG analysis would be conducted at this stage. While we conduct our own ESG research, our credit research team and economists also utilise third-party ESG research.

With respect to corporate credit research, we have a five-step process which integrates ESG factors into our fundamental opinions.

1. Identifying material ESG issues that may have an impact on an issuer on an issuer and documenting those items into our internal research database, Aladdin® Research. This enables our analysts to monitor these issues over time and provide updates to the companies’ progress in addressing them.

2. Our analysts will engage with issuers when we believe the potential ESG items highlighted are material. The objective here is to get a better understanding of how management will address these issues. Our opinion of management’s credibility on ESG issues helps to inform our fundamental credit opinion.

3. Our analysts will document all material ESG issuers in a specific section within our in-depth credit research reports. Here, the analyst highlights the issues and explains how the issues are considered with respect to their fundamental credit opinions.

4. Our newest step is the pending launch of our internal proprietary ESG ratings. After considering potential ESG issues and our engagement with management, our analysts will be assigning an internal ESG ratings. We expect to launch these internal ratings later in 2020.

5. Our final step integrates the analysts and the portfolio managers. The portfolio managers maintain ESG relative value journals which capture all discussions between portfolio managers and analysts regarding ESG issues and our relative value opinion on those issues.

The senior portfolio managers then construct the portfolio along with the team of sector specialists and analysts. The portfolio management team reviews the research before deciding whether or not the issuer has any material ESG concerns. The portfolio managers also ensure that the issuer would not violate any guidelines of the portfolio (including any SRI screens or restrictions).

Portfolio managers and risk managers oversee risk positioning daily, which includes the review of any material ESG issues that would either cause the portfolio to exceed its risk budget or result in a violation of ESG restrictions.

Main Corporate (Financial) ESG Broad Factors for Consideration

Governance

•               Board: Independence, Diversity, Transparency, Experience, Leadership

•               Global Compact Signatory

•               ESG Reporting: Disclosure, Performance Targets

•               Financial Reporting: Disclosure, Timeliness, Transparency

•               Incidents: Business Ethics, Governance, Accounting, Tax, Bribery, etc.

Our investment process begins with the senior investment team assessing the global market environment. This includes the review of any ESG issues by our credit research analysts or global economists. The majority of our ESG analysis would be conducted at this stage. While we conduct our own ESG research, our credit research team and economists also utilise third-party ESG research models.

With respect to corporate credit research, we have a five-step process which integrates ESG factors into our fundamental opinions.

1. Identifying material ESG issues that may have an impact on an issuer on an issuer and documenting those items into our internal research database, Aladdin® Research. This enables our analysts to monitor these issues over time and provide updates to the companies’ progress in addressing them.

2. Our analysts will engage with issuers when we believe the potential ESG items highlighted are material. The objective here is to get a better understanding of how management will address these issues. Our opinion of management’s credibility on ESG issues helps to inform our fundamental credit opinion.

3. Our analysts will document all material ESG issuers in a specific section within our in-depth credit research reports. Here, the analyst highlights the issues and explains how the issues are considered with respect to their fundamental credit opinions.

4. Our newest step is the pending launch of our internal proprietary ESG ratings. After considering potential ESG issues and our engagement with management, our analysts will be assigning an internal ESG ratings. We expect to launch these internal ratings later in 2020.

5. Our final step integrates the analysts and the portfolio managers. The portfolio managers maintain ESG relative value journals which capture all discussions between portfolio managers and analysts regarding ESG issues and our relative value opinion on those issues.

The senior portfolio managers then construct the portfolio along with the team of sector specialists and analysts. The portfolio management team reviews the research before deciding whether or not the issuer has any material ESG concerns. The portfolio managers also ensure that the issuer would not violate any guidelines of the portfolio (including any SRI screens or restrictions).

Portfolio managers and risk managers oversee risk positioning daily, which includes the review of any material ESG issues that would either cause the portfolio to exceed its risk budget or result in a violation of ESG restrictions.

ESG Broad Factors for Consideration

Environmental

•               Overall Environmental Policies

•               Greenhouse Gas (GHG) Reduction Program, Reporting & Trend

•               Water and Wastewater Management Programs

•               Energy Efficiency and Renewable Energy Programs

•               Waste & Hazardous Materials Program

•               Environmental Fines & Penalties

Social

•               Human Rights Policies

•               Working Conditions & Employee Incidents

•               Supply Chain Monitoring

•               Diversity and Inclusion Programmes

•               Data Security & Privacy Breaches

•               Product Safety and Consumer Protections

Governance

•               Board: Independence, Diversity, Transparency, Experience, Leadership

•               Global Compact Signatory

•               ESG Reporting: Disclosure, Performance Targets

•               Financial Reporting: Disclosure, Timeliness, Transparency

•               Incidents: Business Ethics, Governance, Accounting, Tax, Bribery, etc.

In securitised credit, the issues that inform the ESG ratings vary in consideration and can be asset class specific.

Environmental considerations range from Sponsor’s compliance with environmental regulation to broad sustainability issues. We were a lead investor in Fannie Mae’s first Green REMIC multifamily transaction, the proceeds of which were used to encourage apartment building owners to make energy and water-savings improvements; the outcome should be better quality housing with a lower environmental impact and positive cash flows.

Social considerations include lenders' origination and underwriting processes and servicing operations.  Analysts assess if the issuer’s operational practices increases the lender’s exposure to regulatory and/or reputational risks associated with predatory lending laws, disparate impact rulings, and known Consumer Financial Protection Bureau points of emphasis.

Regarding governance, analysts meet with management, audit, legal, and compliance departments to understand oversight of credit underwriting, origination, and servicing practices. Rigorous transaction documentation review helps mitigate shortfalls in the governance of the securitisations themselves.  Examples include identifying conflicts of interest between insiders (Trustees, Servicers, Rep and Warranty providers), identifying intercreditor issues (e.g. senior debt holder’s protection against junior class encroachment), assessing the document’s amendment process and transaction events of default, and ensuring dispute resolution mechanisms are documented and functional.

External Resources

PGIM Fixed Income maintains a partnership with an external vendor, Sustainalytics, a “global leader in ESG & Corporate Governance Research & Ratings” to enhance its ESG review process.