Portfolio Manager Peter Schwab spoke with The Wall Street Transcript (TWST) about his approach to managing the Pax High Yield Bond Fund. In the following interview excerpt, Mr. Schwab illustrates how ESG is integrated into the investment process.
TWST: What does it mean that you are focusing on environmental, social and governance? How does that play out in the fund?
Peter Schwab: Each company that we are contemplating as an investment in this fund needs to meet the criteria that the sustainability team here sets for environmental, social and governance performance. The high yield universe does have a heightened number of companies and some industry concentration that could introduce more than average ESG-related risk, mainly on the environmental side. Energy is a very large component of our index, as are basic materials and utility companies. Within these sectors, and others, the team here at Pax is looking for companies that are doing well managing these issues. We compare them relative to each other within the index, and look for companies that disclose more information and proactively manage these issues.
The idea here is to use ESG research as an incremental risk management tool as well as identify and avoid the laggards. It does provide us with more nonfinancial information than you might otherwise have time to gather. Everything in the portfolio does not necessarily have a clean history in these areas, but they are more likely to be managing ESG risks proactively and responding to us in a manner that we think is appropriate when we interact with them.
TWST: Is there anything about the ESG rule that you might apply that would be a surprise to somebody? What do you think are some of the more important issues in ESG?
Mr. Schwab: We tend to get questions about how a high yield company can be included in an ESG portfolio. The assumption is that high yield companies just by the nature of their credit ratings are poor performers from an ESG perspective, which is generally not true. High yield companies are indebted and often smaller in nature, so the rating agencies can have a bias against size. We have a lot of leveraged buyouts — LBOs — in our index, and they are clearly not going to get an investment-grade rating. There may or may not be any connection between a company’s credit rating, its debt load and its performance on ESG issues.
Having said that, I did mention that we do have a number of more sensitive sectors that make up this index, so we do feel as though we need to scrutinize those companies as carefully as we would otherwise. That’s why we spend a lot of time on the energy sector and the mining sector and certain financial companies that are lending to consumers. Financials are an area often overlooked from an ESG perspective because they generally don’t run into ESG problems. More aggressive consumer lenders in the high yield index may not have very clear and appropriate guidelines when disclosing information to their customers. So, some financial companies are excluded from our investable universe based on ESG criteria. That tends to surprise people.
TWST: Lastly, can you offer some parting words as to how this fund differs from others in its peer group, aside from the fact that you don’t pick the CCC rated bonds? Can you offer that picture as to why an investor would want to choose your fund over another?
Mr. Schwab: First, there are very few of what we would define as fully integrated ESG high yield funds available. This fund is for those who are interested in these issues and want to know the portfolio that they are investing in, despite being high yield companies, is performing well in these areas or at least proactively managing them. The team here at Pax examines different ESG issues depending on the sector and adjusts their focus based on sensitivities within the sector. A lot of people who integrate ESG scores are typically backward looking, and we often don’t agree with the scores that they might get from a third party. We think we are doing a better job of integrating ESG information on a forward looking and dynamic basis.
The fund itself, as I mentioned, does have a more conservative bent to it, and we think it will likely perform well especially in a down market. We don’t have a material duration difference versus the benchmark, and that is intentional. We don’t want to make a directional bet on interest rates and would rather focus on outperforming the index over a full cycle by picking the names that are performing well with manageable downside risk.
The Pax High Yield Bond 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.