Environmental, social and governance (ESG) factors are all important to the sustainability of an investment. Governance may be listed last, but it should never be an afterthought for fixed-income investors. After all, by studying an organization’s governance—the practices and processes used to direct and manage the organization—investors gain vital insight into a country’s or company’s ethos, risk management and overall sustainability.

Bond and Equity Investors Agree on Governance Basics

Equity and fixed-income investors agree that good governance includes fair treatment of stakeholders, accurate and transparent reporting with appropriate disclosures, and minimal conflicts of interest between management and the company. Unfortunately, not all companies rise to these standards.

Consider Carvana, a web-based used car seller, whose bonds have underperformed their CCC-rated peers. The ownership structure includes super-voting shares for the CEO and his father, the company’s largest shareholders, granting them control of the company. The company has relied on ongoing equity offerings to fund itself, which can limit access to capital in the future. And with limited shares available for trading, the stock price and market value have fluctuated wildly. The biggest red flag for us, though, is the CEO’s father’s bank fraud conviction in 1990. The two men remain very close, and the company’s control structure combined with the fraud conviction casts a shadow on company financial statements.

But Fixed-Income and Equity Investors Have Differing Needs

Even when governance is good for equity investors, it isn’t always good enough for credit investors. Bond investors are primarily concerned with reducing risk to their investment, while equity investors focus on increasing returns. Equity investors, for example, might be happy for management to spin off valuable brands to shareholders. However, unless the spin-off assumes a pro rata share of existing debt, leverage and default risk increase for creditors of the remaining company. Shareholders might even ask management to fund significant dividends with debt, which harms credit investors by transferring capital from the company to equity shareholders.

Credit investors need to know that the organization will protect their standing in the capital structure. This is never more critical than during a leveraged buyout (LBO). When the potential LBO of Kohl’s was announced, the share price rose 36%, while the price of bonds maturing in 2037 dropped 10%. Not only would credit investors face increased debt to fund the buyout, but there is also speculation that the acquirers might sell off and re-lease the company’s real estate, reducing the assets available to credit investors.

Trust, but Verify

Strong covenants are essential for bond investors. Every bond issued is a contract between the issuer and the buyer. In addition to stipulating coupon, maturity and par value, the bond’s prospectus almost always contains covenants. Covenants lower borrowing costs for issuers and provide an additional layer of protection for bondholders by limiting the issuer’s ability to take actions that favor another party over the bondholder. Covenants are guardrails, and issuers take these commitments seriously. If an issuer violates a material covenant, the bond may enter technical default, often leading to a rating downgrade and higher borrowing costs.

Investors need to inspect covenants carefully for potential loopholes, however. For example, a common loophole in high-yield bond issues is a covenant that limits a company’s secured debt but doesn’t mention unsecured debt. Companies use this weakness to load the balance sheet with unsecured issues—making the secured debt risk profile significantly better than the unsecured.

Another loophole is one that allows the interests of equity investors to be placed above those of bondholders. Take Party City, which earned a mid-range governance score by a data service but scored much lower under our credit-centric analysis. Why? The pandemic forced the company to close stores for three months in 2020, worsening its already precarious financial situation—the company has a debt-laden balance sheet from its private equity acquisition in 2012. In May 2020, the cash-strapped company asked holders of bonds due in 2023 to exchange them for a new issue due in 2026—at a discount to par. Investors who refused now own bonds that are deeply subordinated to the new 2026 maturity and trading materially lower than similar unsubordinated bonds.

About Those Data Services

Fixed-income investors might wonder why a fundamental assessment of governance is necessary, given bond ratings and ESG data services. These are useful, but their flaws mean that investors must scrutinize governance themselves. Both ratings companies and ESG data services use proprietary methodologies, so they lack transparency and comparability. Plus, ESG services consider governance from an equity investor’s perspective. The result? Their scores come up short from a credit investor’s perspective, and they overlook much of the fixed-income universe, where privately owned companies haven’t issued equity.

Even when rating services have rendered an opinion, original appraisals can be deficient, and situations can deteriorate rapidly. For example, Suriname issued a sovereign 10-year bond in 2016 and a four-year bond in 2019. ESG data services gave the country a governance score at the low end of mid-range. But the availability of the country’s economic and financial data quickly deteriorated after the initial offering, and it appeared that the government would wait to disclose information until it could post a positive quarter. The government was also reluctant to disclose policy plans with investors and pressured local banks to purchase government T-bills at levels above their risk management limits.

An investigation into the country’s political leadership would have indicated that stewardship was suspect: Dési Bouterse, the country’s president from 2010 to 2020, was a former coup leader with convictions for cocaine smuggling and murder, and ties to organized crime. During his tenure, international reserves dwindled, black market exchange rates spiraled and public debt rose from 15% to almost 150% of GDP. The bonds already traded at wide spreads when the pandemic began, worsening an already distressed economy and causing a further hit to bond prices, which fell to 30 cents on the dollar. Suriname officials have failed to reach a restructuring agreement after two years of negotiations.

Integrating governance into the investment process isn’t just about optics. Governance reviews beyond data provided by agencies and services can uncover hidden ethical or structural risks. Governance can also ensure that the issuer’s interests align with those of the bondholder. And no investor wants to find out after the fact that an issuer has poor governance. The difference between a good investment and unexpected losses might come down to the issuer’s governance practices.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

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AllianceBernstein

AllianceBernstein

AllianceBernstein (AB) is a leading global investment management firm that offers high-quality research and diversified investment services to institutional investors, individuals, and private wealth clients in major world markets. We believe corporate responsibility, responsible investing and stewardship are intertwined. To be effective stewards of our clients’ assets, we strive to invest responsibly—assessing, engaging on and integrating material issues, including environmental, social and governance (ESG), and climate change considerations in most of our actively managed strategies. We also believe that strive to hold ourselves as a firm to similar practices that we ask of issues. Our stewardship practices, investment strategy and decision-making are guided by our purpose, mission and values.

Our purpose—pursue insight that unlocks opportunity—inspires our firm to act responsibly. While opportunity means something different to each of our stakeholders; it always means considering the unique goals of each stakeholder. AB’s mission is to help our clients define and achieve their investment goals, explicitly stating what we do to unlock opportunity for our clients. We became a signatory to the Principles for Responsible Investment (PRI) in 2011. This began our journey to formalize our commitment to identify responsible ways to unlock opportunities for our clients through integrating material ESG factors throughout most of our actively managed equity and fixed-income client accounts, funds and strategies. AB also engages issuers where it believes the engagement is in the best financial interest of its clients.

Because we are an active manager, our differentiated insights drive our ability to deliver alpha and design innovative investment solutions. ESG and climate issues are important elements in forming insights and in presenting potential risks and opportunities that can have an effect on the performance of the companies and issuers that we invest in and the portfolios that we build.

Our values provide a framework for the behaviors and actions that deliver on our purpose and mission. Values align our actions. Each value emerges from the firm’s collective character—yet is also aspirational.

• Invest in One Another means that we have a strong organizational culture where diversity is celebrated and mentorship is critical to our success. When we invest in one another, we empower our employees to reach their potential, so that they can help our clients realize theirs. This enables us to partner with clients to design and deliver improved investment outcomes.
• Strive for Distinctive Knowledge means that we collaboratively identify creative solutions to clients’ economic, ESG and climate- related investment challenges through our expertise in a wide range of investment disciplines, close collaboration among our investment experts and creative solutions.
• Speak with Courage and Conviction informs how we engage our AB colleagues and issuers. We seek to learn from other parts of our business to strengthen our own views. And we engage issuers for insight and action by sharing ideas and best practices.
• Act with Integrity—Always is the bedrock of our relationships and has specific meaning for our business. Unlike many other asset managers, we’re singularly focused on providing asset management and research to our clients. We don’t engage in activities that could be distracting, or create conflicts—such as investment banking, insurance writing, commercial banking or proprietary trading for our own account. We are unconflicted and fully accountable.

As of September 30, 2023, AB had $669B in assets under management, $458B of which were ESG-integrated. Additional information about AB may be found on our website, www.alliancebernstein.com.

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