Before even addressing the need to integrate the assessment of ESG factors in credit analysis at the company level, we want to establish a link between ESG factors and credit risk at the sector level.  There is a multitude of ESG factors to consider across all industries.  We must assess their impact on financial materiality as a complement to traditional credit analysis.  However, these factors do not affect all industries in a uniform way. Understanding the relative importance of these factors across different industries helps us to focus the analysis at the company level of some factors versus others.  For example, climate change and carbon footprint will likely have a more material impact on a company’s operating and financial strength in the energy, utilities and bank (from a loan-book perspective) sectors than in the telecom or retail sectors.  As such an analysis of the materiality within ESG analysis at the sector level frames the questions to be asked at the company level.

On a more practical basis, just as our public Credit team scores credit risk and valuations, ESG risks of individual companies based are also scored on a suite of information. Credit analysts review data from various sources, including the  proprietary, quantitative ESG scores (QESG) and analysis generated by our ESG Dashboard. 

The team also employs the use of a proprietary ESG pricing model that it developed in-house based on a collaboration between the investment teams  and the QESG scores.  The pricing model, which was constructed after demonstrating a relationship between ESG factors and credit spreads helps us to make investment decisions about which securities in the capital structure to invest in; where on the credit curve to invest, or simple whether to invest at all in a particularly name. 

The team also has access to engagement information from the stewardship team, EOS at Federated Hermes (“EOS”), and meets regularly with the engagers from the team. Finally, the  Credit analysts often share meetings—often at the board of CEO/CFO level—with their peers in  EOS (e.g., Deutsche Bank, Suzano, Country Garden, Vodafone, Tenet, Telecom Italia, Pemex, etc.).

As outlined elsewhere, we additionally adopt a firm-wide exclusion policy with respect to companies that produce cluster munitions and/or anti-personnel landmines.

The Private Debt team considers ESG items as part of the credit analysis undertaken for each potential investment. ESG considerations are tabled at the Private Debt Investment Committee as part of the research presented for all new transactions.

For our Direct Lending team, the key is to identify meaningful ESG risks, both current and potential, before investing. Due to the difficulty of divesting and the capped upside, it is important to manage the downside ex ante. The Direct Lending team operates a three-pillar approach to ESG analysis:

1. Excluded Industries: The Direct Lending strategies are exclude  investment into any transaction exposed to certain industries and practices, including gambling, tobacco, distilled alcohol, pornography, weapons & munitions, GMO, fur trade, ship breaking, shark finning and cosmetics tested on animal.  This is because the Direct Lending team does not think that investors are remunerated for the ESG risks associated with these industries.
2. Enhanced Due Diligence: Any potential investment exposed to certain industries is subjected to enhanced due diligence, including via with the Responsibility team and EOS, as appropriate. These industries include energy, chemicals, forestry and agricultural commodities, manufacturing and mining and metals.
3. Transaction-specific ESG Analysis: As part of its fundamental credit analysis, the Direct Lending team conducts an ESG assessment of each investment opportunity and applies a rating from one (very low ESG risk) to five (very high risk). E, S and G factors are then weighted by materiality, resulting in an overall weighted average rating. Additionally, the team also focuses acutely on the sensitivity of the company’s cashflows to sudden damage that could arise from the identified potential ESG risks. With that in mind, the Direct Lending team will evaluate if investors are adequately remunerated for the ESG risk(s) of the transaction.

The credit application prepared by the Direct Lending team includes a specific section on the ESG considerations associated with the transaction, highlighting the facts that led to the ESG ratings of the opportunity. These considerations and the rating are discussed and minuted at Investment Committee and a decision is made on whether they are acceptable to the investment case.

As with our direct lending investments, it is important for our Asset Based Lending team to identify risks that may impact on a borrower’s ability to repay their loan.

 As part of our processes and expertise, and as with the rest of our investment portfolios, we have integrated our responsible property investment principles and programme into the debt investment procedures.

It is the responsibility of the debt investment team to implement the strategy.

This is done as follows:

1. Underwriting and due diligence

The focus of our responsibility programme is on ensuring a strong due diligence process including assessments of ESG and climate risks and opportunities before agreeing new loans. This is applicable for every loan.

2. Loan origination & documentation

At loan origination the business plan agreed is included in the loan documentation, it includes all mitigation activities identified and detailed in the asset business plan, asset refurbishment plans and/or planned and preventive maintenance programmes. Also applicable for all loans.

3. Management and monitoring post closure, asset upgrade finance

We collect and manage the sustainability information we hold on the borrowers and the underlying assets.

Where we provide capital for refurbishment, in accordance with the business plan, refurbishment agreements include a review of the Federated Hermes’ responsible refurbishment guide and minimum requirements.

At the portfolio level, the Credit team reviews their ESG risk versus the broader market through the analysis of our proprietary ESG Portfolio Monitor. The report also informs us of the strongest and weakest names from an ESG perspective and which names have "controversies".

We score ESG risks to sovereigns (mostly EMs) on the same one to five scale that we use for sector ESG and issuer ESG.   We are looking for the material impact on credit risk of ESG factors at the sovereign level—rule of law, corruption, strength of institutions, education and health of citizens, vulnerabilities to climate change, etc.  However, because sovereign ESG analysis is in its nascency, we are following the trajectory of ESG analysis we used for the more developed sector and company sets of analysis. To that end, we principally rely on third party information while we develop our own in-house tools from primary sources provided by rating agencies, countries, academia and inter-governmental institutions like the OECD, UN and World Bank.  A lack of timely data remains a challenge, but we think there is a path forward as momentum builds across the industry.  Engagement whilst not impossible, is more challenging than with corporates due to, for example, access and frequency in the market.

For asset based lending, we require the borrower to submit sustainability information alongside appraisal or valuation reports as part of the due diligence process. Findings from the acquisition due diligence are integrated into the decision-making process through risk assessment and mitigation requests. These are then integrated into the asset business plan to be agreed with the borrower. Sources used are the valuation report which must be from an independent professional valuer, UK Environment Agency flood maps, EPC certificate. Demographic factors are reviewed by the Federated Hermes strategy teams using economic data sources, such as Oxford Economics.

In addition to the International business of Federated Hermes  firm-wide exclusion of cluster munitions and anti-personnel landmines, the Credit team excludes companies that are qualified as "controversial weapons manufacturers and/or distributors".

We are always looking for ways to improve our investment process, and this means looking at how we analyse and price ESG factors. To that end, our Credit and the Global Equities team have analysed and established a relationship between ESG factors and securities valuations.  In addition, the credit team meets twice-a-year to do a complete survey of its approach investment process, including ESG integration.  Often, we make changes based on observations of what worked and didn’t work in terms of picking up and pricing ESG risks.

The Direct Lending team carry out enhanced due diligence on certain industries that are deemed to be higher risk. Also, ESG ratings are discussed at each Private Debt Investment Committee for any potential fund investment. 

During the due diligence process, the Asset Based Lending team requires the borrower to submit sustainability information alongside appraisal or valuation reports.

Energy performance is monitored through an EPC register. We measure the flood risk using flood maps from the UK environment agency.

The asset valuation from the independent professional valuer will also comment on other environmental factors, which if significant would be reviewed at investment committee.

Moreover, as with all other scores, the credit team not only analyses the ESG risks, but also attempts to price them on an outright and nominal basis. If the analyst can provide a choice between two names at similar spread levels but of varying ESG quality, the portfolio manager will choose the one with the better ESG scores; the portfolio manager is less likely to select or build significant positions in names with a troubled ESG record.

The Public credit team do not have any norms-based exclusions for the mainstream credit funds. However, they do upload the quarterly controversial company reports produced by EOS to the coverage database in order to ensure that the analysts are aware of any changes to the list and capture materiality in financial risk from non-fundamental factors. 

The Private Debt team considers ESG items as part of the credit analysis undertaken for each potential investment. ESG considerations are tabled at the Private Debt Investment Committee as part of the research presented for all new transactions.

For our Direct Lending team, the key is to identify meaningful ESG risks, both current and potential, before investing. Due to the difficulty of divesting and the capped upside, it is important to manage the downside ex ante. The Direct Lending team operates a three-pillar approach to ESG analysis:

1. Excluded Industries: The Direct Lending strategies are prevented from investing in any transaction exposed to certain industries and practices, including gambling, tobacco, alcohol, weapons, GMO, animal testing and businesses with a negative ecological footprint on natural habitats. This is because the Direct Lending team does not think that investors are remunerated for the ESG risks associated with these industries.
2. Enhanced Due Diligence: Any potential investment exposed to certain industries is subjected to enhanced due diligence, including engaging with the Federated Hermes Responsibility team and  EOS, as appropriate. These industries include energy, chemicals, forestry and agricultural commodities, manufacturing and mining and metals.
3. Transaction-specific ESG Analysis: Each potential investment is analysed at a granular level across the three ESG components, with the analyst identifying potential company and sector-specific ESG risks and mitigants. The analyst assigns a low, medium or high rating to each component. The Direct Lending team do not invest in companies with a ‘high’ risk assigned to any of the E, S or G factors pre-investment.

Information on flood risk is provided by the borrower along with professional independent valuation, EPC rating and financial information as a condition precedent to lending and then annually throughout the term of the loan. Flood risk for UK is measured in line with the UK Environment Agency flood maps and can be verified by Federated Hermes through this source. If any risk of flood is identified, a mitigation or action plan is required from the borrower and reviewed at least annually throughout the term of the loan.

The Hermes SDG Engagement High Yield Credit Strategy aims to provide total return through a combination of income and capital growth, whilst delivering positive societal impact through engagements with companies focused on the United Nations’ Sustainable Development Goals (SDGs). This is a high conviction strategy that invests in high yield companies that demonstrate willingness and ability to create positive change in society and/or environment whilst improving their credit profiles.  

The strategy uses the SDGs, an ambitious, universal set of objectives seeking global prosperity and environmental integrity by 2030, as a framework for engagement. Our engagements seek positive change that strengthens the long term performance of companies, sustaining both impact and corporate profitability. We believe that bondholder engagement supports the long-term viability and investment performance of businesses while also benefiting society and the environment. The global high-yield market offers great opportunities to identify companies with the willingness and ability to change their operations, products or services in order to generate additional benefits for society and the environment. Most high-yield issuers are yet to focus on creating positive change, enabling us to play an important role in their efforts to become impactful while also delivering attractive returns to investors. By investing and engaging to create change, we seek tomorrow’s impact leaders rather than focus on those of today.  

The strategy aims to generate long-term, risk-adjusted outperformance by investing in attractive high-yield credit instruments and engaging with the underlying companies to generate positive impacts that support the SDGs. To achieve this, we combine the global, dynamic investment approach developed by our Credit team with the engagement skills of the Fund’s Lead Engager and EOS, our firm’s stewardship team. Portfolio companies must meet specific investment and engagement criteria. Each should have supportive fundamentals, cash-generative operations and be trading at attractive valuations. Their business lines, supply chains or product or service offerings must provide a foundation to create SDG-aligned impact, and their executive teams and boards must be willing to enter the long-term, transformative process of engagement. Each business must have a stable shareholder base and a long-term vision that shows a willingness to effect positive change. Our high conviction, bottom-up security-selection process results in a portfolio of long-term holdings aligned with the duration of our engagements with the underlying businesses. By investing flexibly, we target opportunities to generate strong returns and income across geographies, instrument types and credit curves.  

To gauge the opportunity for generating SDG-aligned impact, we use a one-to-five scoring system that assesses the credit fundamentals of a company and the scale of the opportunity to create change. Our scores are reviewed and changed in response to changes to the relevant investment and engagement theses, and portfolio holdings and position sizes are adjusted accordingly.  

Believing that long-term bond and equity investors have a mutual interest in the sustainable growth of companies – which requires strong corporate governance and positive influence on society and the environment – we seek opportunities to collaborate with other financial stakeholders on objectives related to the SDGs. 

We rely on disclosed information by the company where metrics vary on a company by company basis allowing for idiosyncratic impacts to be captured. Widely accepted and standardised metrics from IRIS, GRI and other relevant measurements organisations are also used to provide rigour.

One of the key aspects of this strategy is the engagement where specific objectives are set in conjunction with the company and ongoing conversations are held to help the issuer achieves its targets; the objectives are aligned to at least one of the UN SDGs.

We report on individual company case studies to highlight the engagement outcomes and also produce a six monthly and annual report that details the engagement activity and outcomes achieved. 

It is the combination of all the above as we assess how much weight to assign ESG factors as we determine materiality, probability and timing of the impact of ESG factors on a company’s credit risk and, by extension, securities’ valuations.  For sovereigns, the process is relatively new for us but we following the same basic process that we have for corporates, although there are data and engagement access challenges. 

Studies that Federated Hermes (and others) have conducted show that companies with poor environment, social and governance behaviours are more likely to underperform their peers. Moreover, companies with improving ESG behaviours can be excellent investment opportunities because as these improve, uncertainty declines and therefore so does risk, which leads to spread tightening over time. As a result of these conclusions, the Credit team feel compelled to analyse and price ESG risks in addition to traditional operating and financial risks when making investment decisions for credit.

Once a company has been included in the universe, the credit analyst will analyse various factors to understand how much the company's behaviours jeopardize or enhance a company's enterprise value. The criteria do not differ across jurisdictions or sectors. However, the team also recognises that certain sectors are more vulnerable to ESG behaviours, which can lead to sudden degradation in firm value. To that end, whilst the team looks at relative standing of a company within its sector for each of the three components of ESG, for each sector they might emphasize one ESG factor more than others, e.g. Environmental behaviours for Basic Materials and Energy; Governance for Financial Services and Banking; Social for Consumer and Retail.

The main criteria for the governance category is for the analyst to determine the earnestness with which a company seeks to improve all of its behaviours. They must obtain a sense of management desire and credibility to build a sustainable business that will support and perpetuate firm value. From that, the team can have a sense that the controls in place to prevent fraud, environmental damage and employee injuries are genuine. As for the social category, the team seeks to know if controls are sufficient to prevent the production of faulty or dangerous products. The analyst will also want to know that a company is treating its employees fairly and doing what it can for employee safety. Finally, for the environmental category, the team will focus on a company's efforts to reduce its impact on the environment as a sign of their desire to build a company for the long term. However, the team will also focus acutely on a company's susceptibility to sudden damage to the environment, to the extent that it could lead to a sudden loss of firm value, which would have an immediate and direct impact on securities valuations.