Hi, I'm Katie Glass. I'm a Portfolio Manager and Senior Investment Analyst on the High Yield Team at Federated Hermes.
Why is ESG important in high yield credit analysis?
There are really four main reasons that we think about when we add ESG analysis into our traditional fundamental credit research. First and foremost, we're using ESG as a risk mitigation tool. The high yield team is utilizing a proprietary ESG assessment to uncover potential sources of tail risk. You don't wanna have an environmental, social, or governance issue lead to a major downside surprise. So the second part of our framework is to use ESG as a management evaluation tool. For those of you who have been following along to the high yield investment strategy for years, you'd understand that we spend a lot of time talking to management teams.
We are asking ESG questions now to those teams, and it's very much tied to the idea that thoughtful consideration of ESG risks is likely indicative of thoughtful consideration of other risks in their overall business, so that's really what we're trying to uncover, is really how these management teams are dealing with all the risks in their business, and ESG risks, as well. The third thing that we're doing here with ESG integration is trying to identify some risks in the portfolio. We are using ESG as a valuation indicator. We are utilizing our proprietary effective spread analysis to identify companies that have poor ESG practices that may not be reflected in their bond valuation.
At the end of the day, the goal is, really, to identify companies that have high ESG risks, and low credit spreads, so while we would be the first to acknowledge that ESG risks can be present in bonds at all spread levels, the probability of that big surprise that could cause substantial widening of credit spreads is much more likely to impact bonds in our low effective spread category, so the key question that we're asking day in and day out is are you being fairly compensated for ESG risk? The final reason that we believe ESG can be helpful in high yield analysis is using ESG, specifically governance, as a link to debtholder stewardship, so in addition to those environmental, social, and governance consideration, the high yield team is asking ourselves about how companies are dealing with their debtholders. This is essentially adding another pillar to the analysis, so if you think about traditional three pillar environmental, social, and governance, we're now adding debtholder stewardship in there because traditional ESG analysis tends to be more shareholder oriented. Given the complex capital structures that high yield companies have, and the potential for management to try to, perhaps, even circumvent covenants, or avoid some investor protections, we really wanna understand how companies are going to balance the needs of debtholders and shareholders, and use that as a very important analysis tool. At the end of the day, we believe that debtholder stewardship is a particularly relevant tool that we're going to bring into the ESG analysis that we're doing for our portfolio of companies.
Disclosure: Views are as of April 21, 2020 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices. High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited. There is no guarantee that considering environmental, social and governance (ESG) factors will be a successful investment approach. Federated Investment Management Company 20-30170 (4/20)