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.