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The international business of Federated Hermes (formerly Hermes Investment Management)

PRI reporting framework 2020

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ESG incorporation in actively managed fixed income

Implementation processes

FI 01. Incorporation strategies applied

Indicate (1) Which ESG incorporation strategy and/or combination of strategies you apply to your actively managed fixed income investments; and (2) The proportion (+/- 5%) of your total actively managed fixed income investments each strategy applies to.
SSA
0 Screening alone
0 Thematic alone
0 Integration alone
100 Screening + integration strategies
0 Thematic + integration strategies
0 Screening + thematic strategies
0 All three strategies combined
0 No incorporation strategies applied
100%
Corporate (financial)
0 Screening alone
0 Thematic alone
0 Integration alone
95 Screening + integration strategies
0 Thematic + integration strategies
0 Screening + thematic strategies
5 All three strategies combined
0 No incorporation strategies applied
100%
Corporate (non-financial)
0 Screening alone
0 Thematic alone
0 Integration alone
95 Screening + integration strategies
0 Thematic + integration strategies
0 Screening + thematic strategies
5 All three strategies combined
0 No incorporation strategies applied
100%
Securitised
0 Screening alone
0 Thematic alone
0 Integration alone
100 Screening + integration strategies
0 Thematic + integration strategies
0 Screening + thematic strategies
0 All three strategies combined
0 No incorporation strategies applied
100%

01.2. Describe your reasons for choosing a particular ESG incorporation strategy and how combinations of strategies are used.

The International business of Federated Hermes (“Federated Hermes”) believes that credit is particularly well suited to ESG investing because, unlike equities, credit offers a suite of investment options—across capital structure, along credit curves and among various debt instruments of an issuer.  ESG integration creates further precision about where to invest among all of these choices.  It also helps to “break a tie” when having to choose between two or more companies.

Studies that we(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, our fixed income teams feel compelled to analyse and price ESG risks in addition to traditional operating and financial risks when making investment decisions for credit.

 

 

01.3. Additional information [Optional].

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.


FI 02. ESG issues and issuer research

02.1. Indicate which ESG factors you systematically research as part of your analysis on issuers.

Select all that apply
SSA
Corporate (financial)
Corporate (non-financial)
Securitised
Environmental data
Social data
Governance data

02.2. Indicate what format your ESG information comes in and where you typically source it

Indicate who provides this information  

Indicate who provides this information  

Indicate who provides this information  

Indicate who provides this information  

Indicate who provides this information  

02.3. Provide a brief description of the ESG information used, highlighting any differences in sources of information across your ESG incorporation strategies.

The research team of our public credit team breaks down its ESG analysis into three broad levels:  sovereign (mostly for emerging markets countries), sector, and, of course, company.  The analysts score ESG factors on a scale of one (worst) to five (best) across all three areas.  In order to assess ESG risks—materiality, probability and timing—our  Credit team reviews a suite of information drawn from various sources.

We score ESG risks to sovereigns on the same scale. 

At the sector level, meaningful strides have been made over the last few years, which have served as an impetus for us to build out an ESG scoring system for sectors.  We use a combination of external, third-party vendors (SASB, MSCI, rating agencies) for data and information, as well as a suite of information in house—proprietary QESG scores (highlights industry-specific key performance indicators related to social, governance-related and environmental factors); views from the engagement team; and work that the analysts conduct themselves.

Our Direct Lending and Asset Based Lending teams use more qualitative information, due to a lack of third party data, often gained through dialogue with the borrower and information contained in the due diligence packs.

​See FI 02.4 for further detail

02.4. Additional information. [Optional]

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".


FI 03. Processes to ensure analysis is robust

03.1. Indicate how you ensure that your ESG research process is robust:

specify description

          Fundamental bottom-up ESG research is undertaken by analysts in order to complement and enhance the ESG research received by service providers.
        

03.2. Describe how your ESG information or analysis is shared among your investment team.

          ESG information is included in broader financial analyses and credit reviews which are shared via team-wide emails and then stored automatically in an electronic database.
        

03.3. Additional information. [Optional]

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.


(A) Implementation: Screening

FI 04. Types of screening applied

04.1. Indicate the type of screening you conduct.

Select all that apply
SSA
Corporate (financial)
Corporate (non-financial)
Securitised
Negative/exclusionary screening
Positive/best-in-class screening
Norms-based screening

04.2. Describe your approach to screening for internally managed active fixed income

​We adopt a firm-wide exclusion policy of companies that produce cluster munitions and/or anti-personnel landmines.

If a name appears on the Credit team's exclusion list, it is eliminated from the investment universe. These covers companies involved in the manufacturing or distribution of Controversial Weapons (predicated on the principles of the UNGC) or any names that receive an ESG score of five. For the newly-launched SDG Engagement High Yield Fund, additional exclusions include manufacturers of tobacco. (Although tobacco does not appear on a firm-wide exclusion list, the credit team has no exposure to tobacco.) For other scores, the team looks at whether or not the company's ESG behaviours are improving and if the company demonstrates an earnest desire to improve. In this way, companies that optically score poorly could be investment opportunities. If a company makes it through the exclusion list (e.g. no controversial weapons involvement, Credit ESG score of better than five), the Credit team can include it in its investment universe.

The Direct Lending strategies do not invest in 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 animals.

04.3. Additional information. [Optional]

 

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.


FI 05. Examples of ESG factors in screening process

05.1. Provide examples of how ESG factors are included in your screening criteria.

Type of fixed income

ESG factors

Screening

Description of how ESG factors are used as the screening criteria

Federated Hermes Credit do not hold any aerospace names because of controversial weapons.

Type of fixed income

ESG factors

Screening

Description of how ESG factors are used as the screening criteria

The Direct Lending strategies are prevented from investing in 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. 

Type of fixed income

ESG factors

Screening

Description of how ESG factors are used as the screening criteria

The Direct Lending strategy is prohibited from in investing in any transaction where any of the E, S or G components have been assigned a “5/Very High”  rating by the analyst (ratified by Private Debt Investment Committee).

Type of fixed income

ESG factors

Screening

Description of how ESG factors are used as the screening criteria

We exclude companies which receive a rating of 5 (the worst rating) on our internal Credit ESG rating.
Hermes SDG Engagement High Yield Credit strategy excludes manufacturers of tobacco and controversial weapons.
 

05.2. Additional information.


FI 06. Screening - ensuring criteria are met

06.1. Indicate which systems your organisation has to ensure that fund screening criteria are not breached in fixed income investments.

Type of screening
Checks
Negative/exclusionary screening

06.2. Additional information. [Optional]


(B) Implementation: Thematic

FI 07. Thematic investing - overview

07.1. Indicate what proportion of your thematic investments are (totalling up to 100%):

Specify

          investments that are engaged to deliver into at least one of the UN SDGs.
        
100 %

07.2. Describe your organisation’s approach to thematic fixed income investing

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.

07.3. Additional information [OPTIONAL]


FI 08. Thematic investing - themed bond processes

08.1. Indicate whether you encourage transparency and disclosure relating to the issuance of themed bonds as per the Green Bonds Principles, Social Bond Principles, or Sustainability Bond Guidelines..

          We encourage issuers to disclose in line with frameworks that help assess their progress against the UN SDGs. Such as SASB, GRI and TCFD.
        

08.2. Describe the actions you take when issuers do not disburse bond proceeds as described in the offering documents.

This is not applicable given we do not invest in the above mentioned bonds. More info on our thematic investment approach included in 08.3. 

08.3. Additional information. [Optional]

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. 

 


FI 09. Thematic investing - assessing impact

09.1. Indicate how you assess the environmental or social impact of your thematic investments.

          We measure impact of our investments looking at how we deliver into the UN SDGs.
        

09.2. Additional information. [Optional]

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. 


(C) Implementation: Integration

FI 10. Integration overview

10.1. Describe your approach to integrating ESG into traditional financial analysis.

At the core of our Credit team's active investment process is the assessment and pricing of risk. We have learned that astutely assessing ESG factors can be vital in achieving a more comprehensive view of the risks of investing in debt instruments, as well as identifying opportunities.  In addition, Federated Hermes believes that credit is particularly well suited to integrating ESG because, unlike equities, credit offers a suite of options for investing—across capital structure, along credit curves and among various debt instruments of an issuer.  ESG integration creates further precision about where to invest among all of these choices.  It also helps to “break a tie” when having to choose between two or more companies.  The way that this approach manifests itself across sovereign (principally emerging markets), sector and company analysis differs, although the principal is the same.  We are looking how these ESG factors have a material impact on the behaviours, operations and valuations of debt securities. 

 

At the sector level, meaningful strides have been made over the last few years, which have served as an impetus for us to build out an ESG scoring system for sectors.  We use a combination of external, third-party vendors (SASB, MSCI, rating agencies) for data and information, as well as a suite of information in house—proprietary QESG scores (highlights industry-specific key performance indicators related to social, ethical and environmental factors); views from the engagement team; and work that the analysts conduct themselves.

 

For years our Credit team has explicitly considered ESG factors in their company investment process. Just as the team assigns scores that reflect their assessment of credit risk and valuation, it assigns scores to reflect its view of ESG risks. ESG risks are an important consideration during the research process as such risks, in particular those in relation to poor governance practices, have the potential to impact the enterprise value of a company, which in turn influences its creditworthiness.

The assessment of ESG risks considers the extent to which poor ESG activity or policy can damage enterprise value, which is clearly negative for both creditors and owners. Like the credit and value scores, the ESG score is shown on the cover of the credit tear sheet, which provides a snapshot of a company's business fundamentals and captures relative value among peers and within its own debt securities. ESG risks are ranked from 1 (worst) to 5 (best), and space has been carved out on the tear sheet for the analyst to describe his or her specific concerns. These scores are the same as those assigned to other diagnostics like credit, value and a final score. The fundamental question the team seeks to answer is whether they are being compensated for any risks to the enterprise value of a business and thus to the value of its bonds.

The ESG score is informed by both bottom-up fundamental research undertaken by the sector analyst and by top-down ESG ratings, quantitative information provided through our QESG Dashboard, and qualitative insights gleaned by engagements. The use of our proprietary ESG Dashboard ensures that all companies (subject to the availability of the data) can be compared against their peers on a sector, region or global basis with respect to a range of ESG considerations, such as board structure and industry-specific aspects, such as energy efficiency for transportation businesses. Our proprietary QESG Score captures how well a company manages ESG risks, and importantly whether this is improving or not. The QESG Score not only incorporates third-party research indicators, but also the insights of our voting and engagement activity.

Among ESG risks, we believe that poor governance is the most acute, as this can lead to ineffective strategy and incompetent management, as well as intensifying environmental and social risks - all of which can corrode the value of a business and the risk that a company fails to meet its financial obligations no matter how attractive its assets currently are or how much market share it has at present.  Having said that, we also recognise that some ESG risks are more longer term in nature, particularly those affected by climate change.  The impact of climate change on a business could be material, but the timing is more difficult to assess.  Having said that, we want to see that a company at least recognises these probable risks and is provisioning for them. 

Based on our experience, we believe that analysing ESG factors as part of the investment process enhances performance. To us, this is intuitive, although we have increasing evidence to support this hypothesis and are continuing to analyse the links between different ESG factors and the risk and return characteristics of credit securities.

 

The team also employs the use of a proprietary ESG pricing model that it developed in-house based on a collaboration between teams at Federated Hermes 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. 

10.2. Describe how your ESG integration approach is adapted to each of the different types of fixed income you invest in.

SSA

For sovereigns, there are particular challenges to ESG integration due to a paucity of updated data, difficulty in finding that data, and engaging with sovereign issuers.  So while we do lean a bit more on third-party vendors for this analysis, ultimately the goal is the same: address to what end the ESG factors have a material impact on the sovereigns ability and willingness to meet its financial obligations.

We score ESG risks to sovereigns (mostly emerging markets) 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 difficult due to challenges in accessing country officials.

Corporate (financial)

As both lenders and issuers, banks are exposed to ESG-related risks directly and through their balance sheets. We recognise that financial issuers are very highly regulated and often systemically important entities with very complex balance sheets. For many financial issuers, the most tangible direct ESG risks to their creditworthiness relate to their accounting, capital adequacy and governance. In addition, for these issuers there is a focus on their exposure to particular regulatory, litigation and conduct risks, which are, of course, intertwined with assessments of risk and governance.

While the 'indirect' risks banks face through overexposure to particular sectors are complex, we have been paying more attention to banks' exposures to carbon risk through their lending activities in recent times.

Corporate (non-financial)

The Federated Hermes Credit team assesses ESG risks during the research process as such risks have the potential to impact the enterprise value of a company. Corporate governance is the primary consideration, as poorly governed companies are less likely to respect their stakeholders, including bondholders.

The team assesses the extent to which a company is transparent in its dialogue with investors and other stakeholders. This assessment of transparency includes carbon emissions, an issue to which we will continue to give more attention as recent research demonstrates that firms that choose to voluntarily disclose their carbon emissions pay significantly lower spreads on their bank loans, as compared to their non-disclosing counterparts.

As a credit fund manager, we price in the risks of poor ESG exposure and look favourably on companies aiming to improve their management of ESG risks. We do not adopt a dogmatic approach, but instead assess and price in ESG risks in the context of the overall strengths and weaknesses of underlying businesses and take into consideration the materiality of particular issues to the broader sectors in which they operate. By integrating these considerations into their investment processes, the team believes they gain an even better chance to outperform the market.

Securitised

The nature of Private Debt means that it is key to identify meaningful ESG risks before investing, due to the difficulty of divesting and the capped upside. 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.

 

 As outlined in FI 01.2, the Direct Lending team have a list of excluded industries and a list of industries requiring enhanced due diligence to avoid investing in controversial companies with high ESG risks. 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.

Following completion of an investment in the Direct Lending funds, the ESG risks, like all credit risks, are monitored for any changes. ESG ratings are reported to investors on a quarterly basis. Should an ESG issue arise during the life of the investment, the Direct Lending team will seek to engage with the sponsor and management of the borrower to rectify or improve the ESG issue.

The approach of the Asset Based Lending team is also less quantitative due to a lack of consistent data. We include information requirements in all of our loan documentation to ensure that the borrower passes on relevant ESG information that they have to us, which we use to monitor ESG in our investments. Many of our Real Estate Debt loans support assets where there is a wider impact being delivered, such as refurbishments and regeneration. These factors are a strong consideration before investments are made, as are risks posed by ESG factors. As with our direct lending investments, the key is to identify risks that may impact on a borrower’s ability to repay their loan. 

10.3. Additional information [OPTIONAL]


FI 11. Integration - ESG information in investment processes

11.1. Indicate how ESG information is typically used as part of your investment process.

Select all that apply
SSA
Corporate (financial)
Corporate (non-financial)
Securitised
ESG analysis is integrated into fundamental analysis
ESG analysis is used to adjust the internal credit assessments of issuers.
ESG analysis is used to adjust forecasted financials and future cash flow estimates.
ESG analysis impacts the ranking of an issuer relative to a chosen peer group.
An issuer`s ESG bond spreads and its relative value versus its sector peers are analysed to find out if all risks are priced in.
The impact of ESG analysis on bonds of an issuer with different durations/maturities are analysed.
Sensitivity analysis and scenario analysis are applied to valuation models to compare the difference between base-case and ESG-integrated security valuation.
ESG analysis is integrated into portfolio weighting decisions.
Companies, sectors, countries and currency and monitored for changes in ESG exposure and for breaches of risk limits.
The ESG profile of portfolios is examined for securities with high ESG risks and assessed relative to the ESG profile of a benchmark.
Other, specify in Additional Information

11.2. Additional information [OPTIONAL]

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. 


FI 12. Integration - E,S and G issues reviewed

12.1. Indicate the extent to which ESG issues are reviewed in your integration process.

Environment
Social
Governance
SSA

Environmental

Social

Governance

Corporate (financial)

Environmental

Social

Governance

Corporate (non-financial)

Environmental

Social

Governance

Securitised

Environmental

Social

Governance

12.2. Please provide more detail on how you review E, S and/or G factors in your integration process.

SSA

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.   It is early days, but we know this is the right path to follow.  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, e.g., access, frequency in the market.

Corporate (financial)

Please see previous answers to FI 11.1 and 11.2 for information about our approach.

For many financial issuers, the most tangible direct ESG risks to their creditworthiness relate to accounting and governance issues. For these issuers particular attention is paid to their exposure to regulatory, litigation and conduct risks, which are intertwined with assessments of risk and governance.

Corporate (non-financial)

Federated Hermes Credit integrates ESG factors into investment decisions, alongside more traditional operating and financial risks. As a basic concept, poorly governed companies are less likely to respect their stakeholders, including bondholders. We do not adopt a dogmatic approach, but instead assess and price in ESG risks in the context of the overall strengths and weaknesses of underlying businesses and with a view to the materiality of particular E, S and G issues to the broad sector in which the issuer operates.

A number of integral inputs help Federated Hermes Credit make the best-informed ESG decisions:

  • Firm policies, approach, and investment tools are provided by the responsibility team.
  • At a company-specific level, the team reviews Federated Hermes' proprietary measure of ESG risk - the QESG scores (with 'Q' denoting the quantitative process employed). These QESG scores represent a good snapshot of the overall ESG performance of a company. The team will also review the controversies identified for the stock and consider how serious they are and how current.
  • The engagement team, EOS, provides company information. The dialogue EOS has with a company provides the context of the QESG score. For example, is the company on the right trajectory, or is it more on a negative path?

By collaborating with investment, responsibility and engagement teams, the resulting ESG contribution to investment decisions is more dynamic than, for example, simply relying on scores or historical controversy information alone. And, more importantly, because we engage as an investor, companies are more likely to be responsive.

When we identify a significant ESG risk in a company, we work with EOS to learn more: what actions are underway to improve the situation? What are the implications for long-term returns?

Securitised

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

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 private credit team do not invest in companies with a ‘high’ risk assigned to any of the E, S or G factors pre-investment. These scores impact the decision to invest or not. Scores are affirmed or amended by the Private Debt investment committee.

Energy performance is monitored through an EPC register. We measure the flood risk using flood maps from the UK environment agency. A poorly graded EPC (F or G) or significant flood risk will be flagged and integrated in final decision making; either requiring a mitigation action plan from the sponsor or decision not to lend.

The asset valuation from the independent professional valuer will also comment on other environmental factors, which if significant would be reviewed at investment committee. Where available, energy, water and waste consumption figures are requested from the borrower and could be included in the investment paper. However, at present any necessary action would be worked on in conjunction with the sponsor during the term of the loan, rather than at investment committee.

12.3. Additional information.[OPTIONAL]

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.


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