We believe analysis of environmental, social and governance factors (ESG) can complement classic fundamental analysis to help identify material business risks. When it comes to high yield fixed income, a thorough understanding of operational risks, which include ESG factors, is an especially critical consideration given high yield’s exposure to companies with higher financial risk.
At Federated Hermes, we have developed a proprietary framework for incorporating ESG factors into the investment process. Used alongside intensive, research-driven, fundamental analysis, ESG integration is part and parcel of what we do every day to uncover the risks and opportunities that translate to the potential for strong long-term performance for our clients.
Understanding and evaluating ESG risks as part of high yield credit research provides additional insight to uncovering potential sources of tail risk. Tail risks are events that have a small probability of occurring, but can incite large moves in security prices, especially to the downside—as demonstrated by the tragic consequences of the coronavirus pandemic. Oil spills, data breaches and safety violations (or identifying companies that may have a higher probability of these occurring) are all examples of tail risks that would not be uncovered by traditional fundamental analysis. While analysis of ESG factors may not predict specific events like these, it can provide insights into the likelihood of these events and a company’s internal controls to mitigate these risks. That may lead a portfolio manager to reconsider a particular investment or avoid a new potential investment on the basis of a weak ESG profile.
Hurdles with integrating ESG factors in high-yield analysis
The high yield market presents a unique set of challenges for ESG as issuers may be smaller in size. This limits disclosure versus large-cap companies in the public markets. The resulting lack of transparency around a business’s operations makes stringent first-hand research and analysis a critical component of our investment process. That same lack of transparency applies to sourcing credible data related to ESG factors. Even though demand from investors around ESG issues has rapidly increased, the response from issuers typically found in the high-yield universe is not currently robust. The lack of disclosure in our market segment means third-party ESG ratings may not accurately reflect the ESG profile of a given company and are of minimal value to credit analysts. Further, third-party ESG data is by design backward-looking, reactive in nature and often inconsistent across various sources.
The power of engagement
Given limited disclosure on ESG metrics and policies from high yield issuers, we believe engagement with companies is paramount to fully understanding and evaluating their material ESG risks. Federated Hermes has deep resources to pursue company engagement. In addition to the high yield team’s broad interaction with issuers, our investment team uniquely benefits from direct access to EOS at Federated Hermes, a pioneer and global leader in active engagement.
Engagement is proactive, forward-looking and goes right to the source. We believe there is no better way to understand a company’s risks and opportunities and to advocate for stronger compliance systems, better governance and improved sustainability efforts. Engagement, combined with our intensive focus on each company’s business and financial fundamentals, is a key informational advantage and, ultimately, enhances our risk management.
The ESG journey continues
Demographic shifts, governance trends and growing concern over social inequality and environmental risks are accelerating widespread awareness of ESG factors and their relationship to investment performance. We believe the voices asking for ESG principles to be implemented across industries and companies will only grow louder.
From our perspective, analysis of high yield companies has always required an intensive “kick the tires” approach, and incorporating ESG factors is no different. Over time, our investment analysis also will benefit from increased EOS engagement of high yield issuers. As more engagers are interacting with high yield issuers on ESG topics, we will get a more comprehensive view of long-term structural ESG risks impacting our issuers.
By their very definition, high yield issuers carry more financial risk. The Federated Hermes high yield investment team is focused on fully evaluating all operational risk factors, including material ESG factors. The additional resources we can garner through interactions with EOS subject matter experts and learnings we can glean from their engagements give us further evaluative opportunities we feel are unrivaled among high-yield managers.
Find out more about the Federated Hermes US High Yield Credit Strategy
EOS at Federated Hermes is a leading stewardship service provider. Our engagement activities enable long-term institutional investors to be more active owners of their assets, through dialogue with companies on environmental, social and governance issues. Find out more.
