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

PRI reporting framework 2020

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You are in Direct - Fixed Income » ESG incorporation in actively managed fixed income » Implementation processes

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.


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