Part one of a special three part Sustainability Finance Report for this week by Reynard Loki.
Bloomberg and Calvert Investments Share Tools and Processes to Apply ESG Factors to Fixed Income Investment Analysis
The steady growth of sustainability across the equity investing landscape—stocks, ETFs and even exchanges—has given investors interested in SRI (socially responsible investing) more to chew on when considering ESG (environmental, social, governance) factors in their investment decisions.
But what about ESG integration on the fixed-income side? For many investors—particularly older investors for whom bonds represent a substantial portion of the portfolio—incorporating ESG factors has become an increasingly important aspect of the investment research process. However, assessing the relevance of ESG impact on an issuer's default risk remains a challenge. A recent webinar helped shed light on this emergent area of SRI.
Co-hosted by Bloomberg and Calvert Investments, "Bonding with ESG: Integration in Fixed Income Analysis" was a show-and-tell for both organizations. From Calvert, attendees got a behind-the-scenes look at the firm’s internal fixed income investment decision-making process. From Bloomberg, attendees were introduced to Bloomberg Professional service platform tools available for ESG integration in fixed income investment analysis. By providing an overview of the current state of fixed income ESG analysis, the webinar gave attendees some key tools and approaches to help identify broader sustainable finance opportunities.
CALVERT’S INTEGRATED RESEARCH PROCESS
From Calvert Investment Management, Kim Nguyen-Taylor, Senior Credit Analyst, and Erica Lasdon, Senior Sustainability Analyst, presented the firm's ESG integration strategy for fixed income analysis.
At Calvert, where credit analysts and portfolio managers leverage the expertise of the firm's unique stand alone sustainability research department of 11 staffers, both the fundamental and ESG processes occur simultaneously with the common goal to uncover ESG-related risk and opportunities.
First, a specific issuer is assessed across various structural considerations, such as ratings, maturity, size of issue, security, covenants and where it ranks within the capital structure. Then the company is looked at within the larger context of its sector, considering such themes as competition, event risk, cyclicality and seasonality. Finally, to get an in-depth understanding of the company, they conduct a bottom's up analysis, which would typically include reviewing such elements as products and services, sales growth, profitability, cash flow, debt ratio, price earnings valuations and dividend yield.
"Our process is a disciplined, rigorous, market-focused relative value-driven approach that we apply across the entire investment process—from the time we evaluate a new issue for potential inclusion in the portfolio to monitoring a credit as a secondary holding, to the risk-monitoring process where we may screen a credit for ESG-related idiosyncratic risk," said Nguyen-Taylor, who leads Calvert's ESG integration strategy for fixed income analysis.
FAVORABLE VIEW: VERIZON
The Calvert team used Verizon (NYSE:VZ) as an example of their analytical process. On the fundamental side, the telecom giant acquired its remaining stake of Verizon Wireless from Vodafone (LSE:VOD), a move that not only gave the company complete control over its large free cash flow and the financial flexibility to make spectrum purchases and capital investments, but an overall dominant position in the mobile sector. During this period, the company maintained solid margins, increased its top line at a favorable rate and demonstrated progress in deleveraging.
"We've had a rather favorable view," said Nguyen-Taylor about Verizon, "given its large scale and domestically having arguably the best wireless network." She added that the company is "committed to its investment-grade rating."
On the ESG side of their analysis, the team focused on Verizon's biggest material impacts—primarily its role in the hot-button issue of privacy and surveillance. Lasdon noted that the company was one of the first in the telecommunications space to address this issue by releasing transparency and disclosure reports regarding government requests for individual information. However, she also noted that they lost contracts in Germany based on privacy concerns with a number of U.S. companies.
In addition, they reviewed Verizon's contentious labor relations history in its wireline division. But since this division was becoming an increasingly less important part of the company’s operations, Lasdon asserted that, while the issue is ongoing, it has "less relevance on the company’s bottom line."
In their final relative value analysis, the team combined the fundamental and ESG assessments to ascertain whether the return profile was commensurate with the fundamental and ESG risks. They then created an integrated rating that appears on their internal information sharing platform, a dynamic system where portfolio managers, credit analysts and sustainability researchers can comment on any issue in real-time.
"We're trying to assess whether the valuation looks fair versus peers, and we want to see whether the security is trading fair or cheap versus different instruments," said Nguyen-Taylor. "In the case of Verizon, we felt that the bond was attractive along certain parts of the credit curve versus the wireless sector. We also felt that the bonds were trading fairly versus credit default swaps and when looking at the credit-equity volatility relationship."
A SECTOR-BASED ESG ANALYSIS: AIRLINE INDUSTRY
It is also worthwhile to look at ESG factors on a sector level. In choosing an example of the sector-based framework that they have developed for ESG-integrated research, the Calvert team used the airline industry because "it demonstrates the corresponding impact of environmental factors, which are a particularly pervasive theme in the airline sector on the cost structure of an airline company," said Nguyen-Taylor.
Calvert worked with sustainability experts in the airline industry to identify specific issues that most influence an airline company's cost structure, such as energy intensity, waste intensity and greenhouse gas emission intensity. For airline executives, the impact on cost structure is clear: The younger your aircraft fleet, the better your efficiency metrics are and the less vulnerable you are to energy price volatility, which can force airline companies with older planes to make labor expense cutbacks in order to preserve overall cost structures.
"This could create reputational damage or fleet groundings and have financial repercussions," warned Nguyen-Taylor. "So there is a clear relationship between these environmental themes and energy efficiency metrics with the cost structure of an airline company. Also in the airline space, we typically invest in enhanced equipment trust certificates, and we've typically favored the newer deals which are typically backed by younger, more energy-efficient, more modern fleets. And these newer deals also tend to be structured with superior credit protection. So we would typically see lower loan-to-value ratios, higher collateral coverage, higher recovery rates and other enhancements such as cross defaults and cross-collaterization features."
…Set a reminder for Part Two to be published on Wednesday 3rd December.