Perhaps you’ve heard: ESG isn’t just for equities. Research by Barclays shows that a positive ESG tilt, when applied to the credit markets, resulted in a small but steady performance advantage. Other research from Hermes Investment Management and Breckinridge Capital Advisors & MIT
center on the beneficial relationship between ESG and credit quality.
Clearly, the benefits of ESG are not limited to the equity market. And the practice of integrating ESG research into fixed income portfolio management is not new. At Pax, we’ve applied a sustainable investing approach to the high yield asset class since 1999, when we launched the Pax High Yield Bond Fund (PXHIX).
Still, it can be difficult for investors to conceptualize the benefits of this approach and how ESG research is actually integrated into high yield portfolio management. By illustrating our approach along with sector-specific examples, we hope to shed light on how ESG supports credit selection and risk management in high yield.
In our view, the same value that ESG analysis provides equity investing can also be applied to corporate credit selection. Through the integration of our own ESG research we can gain additional fundamental insight and added risk management, both of which are critical to the evaluation of high yield bonds due to the heightened financial risk embedded in these companies.
Each company that we are contemplating as an investment for the Fund needs to meet the criteria that the Pax Sustainability Research team sets for ESG performance. The team conducts original research on a company’s past performance and current management of ESG risks and opportunities that are specific to its sector.
“The focus is on identifying credible management teams, improving or stable ESG profiles and sustainable business practices.”
Based on this analysis, a determination is made whether the ESG risks outweigh other components of a company’s operating and financial profile. The goal is to steer clear of companies that are laggards in their industries and instead focus on well-managed companies with stronger fundamentals.
Companies determined to have severe, re-occurring or unmitigated controversies, are not eligible to be included in the Fund. We estimate that this process results in a potential investable universe of up to 82% of the Fund’s benchmark, which provides an ample opportunity set at any one time (see Figure 1 below).
Figure 1: This chart shows the percentage of securities in the high yield universe that met Pax’s ESG criteria, did not meet Pax’s ESG criteria, and were not under investment consideration during the period from 2015 through 2017.
Source: Pax analysis. Benchmark universe represented by BAML BB-B Cash Pay Index.
The composition of the Fund’s benchmark has a larger concentration of sectors that have higher ESG risks such as Energy, Basic Industry (metals & mining) and Utilities. These commodity-sensitive sectors are roughly double the weight of the same S&P 500 Index sectors as illustrated in Figure 2 below.
Figure 2: This chart shows the increased concentration of Energy, Basic Industry and Utility sectors securities in the high yield universe relative to the large cap equity universe.
Source: Standard and Poors, Bank of America Merrill Lynch, Factset, as of 12/31/17.
As a result, the extra layer of ESG analysis helps further scrutinize companies in these sectors and proves useful as a risk mitigation tool. A significant amount of time is spent evaluating companies in the Energy sector, the Mining sector, consumer-lending companies and certain pharmaceutical companies involved in aggressive pricing practices.
Within these sectors, and others, we compare companies relative to each other to identify those that disclose more information and proactively manage these issues.
Notably, ESG data is not always available for many of the small, privately held companies in the Fund’s benchmark (think of leveraged buyouts). As such, having an in-house ESG research team is beneficial since it allows us to more completely cover and fully evaluate the investment universe from a sustainability perspective. Third-party data also tends to punish companies for a lack of ESG disclosure without considering other factors, such as size, industry, appropriate peers, etc. For example, carbon emissions data for the Fund’s benchmark is limited. In fact, only 22% of companies in the benchmark report their carbon emissions data.1
The environmental impact from energy and power production and distribution is a key ESG issue for energy and utility companies. Pollution from company facilities and water-intensive operations can be sources of financial liabilities, or even disruptions to company operations. A company’s geographic location can further exacerbate these risks, such as operating in drought-prone areas.
For example, a Ceres report2 about water demand in hydraulic fracturing operations across the U.S. and western Canada found that “nearly half of the wells hydraulically fractured since 2011 were in regions with high or extremely high water stress, and over 55 percent were in areas experiencing drought.”
Climate change is another key issue for these sectors. As we transition to a more sustainable global economy, the long-term nature of assets in the Energy and Utility sectors may present economic risks, particularly for higher cost, more carbon-intensive fossil fuels. Natural gas, which emits approximately 50% less carbon than coal when combusted, will play a meaningful role in that transition.
“These environmental risk factors, along with related social and governance issues, should not be ignored by high yield investors.”
We seek companies that have lower ESG-related risks relative to their peers, that are making progress on key ESG issues. For example, NextEra Energy Operating Power3 and Terraform, two utility companies that generate 100% of their combined 5.6 GW of electricity from solar and wind, are well positioned on the long-term trend towards low-carbon energy production, and have long-term (greater than 15 years) customer agreements that provide stable and predictable cash flows.
Conversely, Pax avoids the most carbon-intensive industries outright: pure-play coal and oil sands mining companies, as well as coal-intensive utilities that generate more than one third of their electricity from coal.
Two pharmaceutical companies account for about 80% of the sector weight in the Fund’s benchmark. Based on our sustainability analysis we determined both companies are outliers compared to their peers on ESG issues due to a combination of poor product stewardship and corporate governance.
In October 2015, we initiated a review of one of the pharmaceutical companies, which was held in the Fund, because of news reports of federal drug pricing investigations. At the time, we were concerned that the scope of the company’s price increases—magnitude of increase and the number of affected products—were significantly higher than the industry at large and unsustainable. Ultimately, the Pax Sustainability Research team recommended divesting from the Fund’s position in the company.
Similarly, and more recently, we came to a decision to divest from another pharmaceutical company because of the controversies surrounding the pricing of one of its drugs, which accounted for about a third of the company’s sales. This decision helped Pax avoid a selloff in both the debt and equity securities issued by the company following the its November 2017 earnings report.
Sustainable investors want to know that the portfolio they are investing in is either performing well in important ESG areas or proactively managing ESG risk. In high yield, just like equities, it is possible to identify and analyze ESG risks and opportunities on the individual security level and apply that expertise to portfolio construction.
For instance, in the environmentally-sensitive sectors, our investment process has resulted in a portfolio that is tilted away from higher environmental-risk companies (coal, tar sands, and poor environmental track records) and towards companies with stronger track records, smaller carbon footprints, and renewable energy.
In our experience, success integrating ESG information into high yield investing rests on doing so on a forward looking and dynamic basis.
Top ten Pax High Yield Bond Fund holdings as of 12/31/17: HCA, Inc., 5.875%, 2/15/26 1.3%, Sally Holdings LLC, 5.625%, 12/1/25 0.8%, Ard Finance SA, 7.125%, 9/15/23 0.8%, Charlotte Russe, Inc., 6.750%, 05/21/19 0.8%, Royal Bank Of Scotland PLC, 6.125%, 12/15/22 0.8%, Fly Leasing, Ltd., 6.375%, 10/15/21 0.8%, Sirius XM Radio, Inc., 5.375%, 4/15/25 0.8%, Sprint Communications, Inc., 7.000%, 8/15/20 0.8%, First Data Corp., 5.000%, 1/15/24 0.7% and Bluescope Steel Finance LLC, 6.500%, 5/15/21 0.7%. Holdings are subject to change.
RISKS: The Fund can invest in “junk bonds” which are considered predominately speculative with respect to the issuer’s continuing ability to make principal and interest payments when due. Yield and share price will vary with changes in interest rates and market conditions. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. There is also a chance that some of the fund’s holdings may have their credit rating downgraded or may default.
The statements and opinions expressed are those of the authors of this report. All information is historical and not indicative of future results and subject to change. This information is not a recommendation to buy or sell any security.