This report shows public data only. Is this your organisation? If so, login here to view your full report.

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

PRI reporting framework 2020

Export Public Responses
Pdf-img

You are in Direct - Fixed Income » ESG incorporation in actively managed fixed income » (C) Implementation: Integration

(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.


Top