Securitizing Sustainability: Structured Debt Goes Green

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Sustainability challenges surround us— from climate change and resource scarcity to inequality and poverty. In order to meet the needs of society, while protecting the environment, improving health outcomes, expanding economic opportunity and improving human capital, companies and countries are quickly evolving their practices, products and services. Members of the United Nations agree that sustainability issues are urgent. In 2015 all 193 countries agreed to support the UN's 17 Sustainable Development Goals (SDGs).

This secular shift toward sustainability has given way to a variety of sustainability-themed investment strategies. We believe structured credit can play a key role in contributing to achieving sustainable investment objectives. While numerous sustainable opportunities exist, sustainable investing is not straightforward. In this paper, we will define sustainability; explore what role structured products play in supporting sustainable initiatives; and explain how we use qualitative and quantitative sources to identify and qualify sustainable investment candidates.

Sustainability defined

At Aegon AM US, we define sustainability as a global economic state that meets the needs and aspirations of people today and in the future, while protecting and improving the environment and preserving the quality of life for all.

The shift toward sustainability affects a broad array of industries, presenting opportunities to invest alongside various sustainable initiatives, or megatrends. Broadly speaking, we group investment opportunities into five key sustainability pillars: climate change, ecological (eco) solutions, resource efficiency, health and well-being and sustainable growth. Opportunities within these pillars can also align with many of UN's Sustainable Development Goals, which provide a broad framework to help determine sustainability.

Structured bonds can support sustainable initiatives

Securitized products, asset-backed securities (ABS), commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS), can support sustainability objectives by providing direct financing for distinct assets and collateral pools, as well as lowering sustainable issuers' cost of capital. Most notably, securitization has played a key role in delivering low-cost financing to affordable housing, clean energy, energy efficiency, sustainable commercial real estate and higher education. For example, solar ABS finances the purchase and installation of photovoltaic electrical generation equipment, promoting ecological solutions and renewable energy. Properties with best-in-class green building certifications that encourage resource efficiency can be financed through single asset/single borrower (SASB) CMBS transactions. In RMBS, securitization has facilitated the viability of mortgage modifications in lieu of foreclosure for borrowers facing financial hardship.

A tailored approach to assessing sustainability

Within fixed income, sustainable investing requires a tailored approach depending on the sector and issuer type. Structured securities primarily derive their value from the quality of the collateral pool, structure and issuer. As such, assessing a securitization's sustainability profile seeks to establish the degree of alignment between the issuer and/or collateral with sustainable initiatives, and equally important, identify if the issuer has products or services against sustainable goals.

Qualitative and quantitative sustainability considerations Sustainability considerations include qualitative and quantitative information, as well as a combination of top-down and bottom-up factors. From a top-down perspective, alignment with broad sustainable initiatives can be identified across sectors, issuers and transactions based on potential business model and/or collateral types (Exhibit 1). By monitoring broad macro trends, such as evolving regulations, governmental policy mandates and consumer behavior, it's possible to identify structured sectors that are inherently aligned with sustainable goals.

Exhibit 1: Examples of structured sectors and issuers aligned with sustainable initiatives

Sector/Issuer Sustainability Pillars SDGs Alignment
Agency RMBS and CMBS Sustainable growth   US Congressional mandate to support housing affordability.
Single Asset/Single Borrower CMBS Climate change   Finances properties with green building ratings or certifications such as LEED Silver or greater, Energy STAR or other equivalent.
Solar ABS Eco solutions   Finances the purchase and installation of photovoltaic electrical generation equipment.
Student Loan ABS Health & Well-being   Secured by loans made to individuals to finance higher education.
Agency CMBS Eco solutions   Finances energy efficiency and other socially-beneficial improvements to real estate by leveraging governments' ability to levy property taxes.

Source: Aegon AM US

Bottom-up considerations focus on the underlying collateral and issuer sustainability. Qualitatively, the degree and scope of alignment with specific sustainable initiatives can be identified by evaluating the issuer's business model and collateral composition. This analysis may include an organizational mission statement review, dialogue with company management, research on the issuer/transaction's sustainability impact, and/or third-party research provider review. Quantitatively, collateral pool composition metrics can be used to determine compatibility with a sustainability thesis.

The securitized sustainability research process is centered on proprietary analysis supplemented by third-party sources. While external data is an important input into the research process, independent viewpoints from experienced analysts with deep knowledge across collateral categories, transaction structures and issuer types are invaluable to synthesizing the plethora of available information into an actionable sustainability investment recommendation. External information can be sourced from a wide range of sources including the issuer, third-party databases such as the US Green Building Council's LEED projects directory, government agencies, academic institutions, think tanks and policy advocacy groups.

Uncovering opportunities through engagement

Proactive engagement with issuers can reveal additional sustainable investment opportunities. Dialogue with issuers is essential to analyzing business practices and governance factors such as origination, servicing and disclosure and evaluating their impact on both transaction credit performance and sustainability. Securitization investors' proximity to the assets being financed can provide opportunities to voice our views with issuers around sustainability and ESG considerations in their products, services or business practices. Securitization issuers can often provide detailed information on their financing programs, origination practices and collateral composition that can be used to evaluate alignment with sustainability pillars and resolve inadequate disclosure. In some instances such as equipment finance securitizations, this information may allow for a more detailed analysis of sustainability considerations than what might be available to a traditional corporate or equity investor.

Evaluating the potential impact of sustainable investment candidates

After assessing top-down and bottom-up sustainability factors, potential investments can be further segmented into categories based on the level of alignment with sustainability pillars. This step is critical to help prioritize investment recommendations for sustainability-themed strategies and help identify the potential impact.

Exhibit 2: Examples of structured sectors and issuers aligned with sustainable initiatives

Impact Category Definition Representative Sectors
Leader Substantial portion of collateral or organizational mission is aligned with sustainable initiatives Agency RMBS and CMBS
Solar ABS
Green Building SASB CMBS
Re-performing Mortgage Loan Securitizations
Influencer Material portion of collateral or organizational mission is linked to sustainable initiatives Life Science SASB CMBS
Improver Corporate issuer deemed an Improver and securitization is a material financing mechanism for the business Varies; specific corporate-securitized hybrid situations such as equipment ABS
Neutral Non-material (or no) portion of collateral or organizational mission linked to sustainable initiatives Credit Card ABS
Shipping Container ABS
Detrimental Significant product and services against SDGs, either:
- On exclusion list, or
- Other situations as determined by the committee (e.g., opioids, product safety, for-profit colleges, etc.)
Hard money lending
Payday loans

Structured opportunities exist across sustainability pillars

Within structured credit, sustainability is represented across all sustainability pillars: Climate Change, Eco Solutions, Resource Efficiency, Health & Well-being and Sustainable Growth.

Exhibit 3: Investable fixed income sustainability pillars

Sustainability Pillar Investable areas Sector Examples
Climate Change - "Green" buildings
- Recycling and composting services
- Environmental
- SASB CMBS
- REITS
- Green bonds
Eco Solutions - Renewable energy
- Hybrid/electric vehicles
- Cloud-based computing

- Technology
- Data Center ABS
- Automotive
Solar ABS
Resource Efficiency - Use of recycled inputs
- Sustainable agriculture
- Water services
- Agriculture
- Paper/ packaging
- Commercial PACE
Health & Well-being - Nutritious, sufficient food
- Personal hygiene
- Medicines and vaccines
- Educational services
- Consumer products
- Pharmaceuticals
- Student loan ABS
Sustainable Growth - Affordable housing
- Mass transit
- Stable, effective sovereign governments
- Agency MBS
- Sovereigns
- Transportation

Source: Aegon AM US

  • Sustainable growth – This is the most broadly represented sustainable securitized sector due to the linkage to affordable housing with housing finance representing approximately 80% of total securitized debt outstanding as of June 30, 2019 according to SIFMA data. This is a reflection of US economic activity; the National Association of Home Builders estimates that housing represents 15%-18% of GDP. As such, securitization plays a key role in supporting housing affordability broadly, as well as facilitating greater flexibility that can lead to improved outcomes for distressed borrowers.
  • Climate change – This category is typically represented by the commercial real estate sector through best-in-class green building construction, design and operations that address resource. For example, many of the high-quality Class A office properties that have been financed in the CMBS market are leaders in adopting green building design.
  • Eco solutions – ABS markets have provided low-cost financing for businesses such as residential solar energy providers and data center operators that promote renewable energy and energy efficiency.
  • Health & well-being – ABS markets can support health and well-being by allowing borrowers who have become established in their careers and demonstrated consistent creditworthiness to reduce their debt burdens ex-post by refinancing their student loans at lower rates that reflect their improved post-graduation credit profile.
  • Resource efficiency – Sectors such as Commercial PACE support resource conservation improvements to commercial real estate such as water efficiency upgrades.

Sustainable case studies in structured credit

The following case studies illustrate how our sustainability assessment process is applied to securitized investment opportunities.

Case Study #1 – Sustainable
Security Description Re-Performing Mortgage Loan Securitizations (RPLs)
Investment opportunity Securitizations collateralized by residential mortgage loans that were modified due to payment delinquency and have demonstrated a clean payment history post-modification.
Sustainability analysis Post-global financial crisis, private capital has emerged that is willing to purchase RPLs, giving viability to sustainable mortgage modifications as an alternative to foreclosure. Affordable mortgage modifications can be a better outcome than foreclosure for distressed borrowers and their communities. Evidence suggests borrower defaults are heavily linked to idiosyncratic income shocks that may be best addressed through modification instead of foreclosure. Foreclosure has a significant cost on communities through adverse property value impacts, drain on scarce local government resources and housing instability for vulnerable populations, most notably for children and the elderly.
Sustainability Pillar Sustainable Growth
SDG Alignment UN SDG 11 – Sustainable Cities and Communities
Sustainability determination Impact Leader

 

Case Study #2 – Sustainable
Security Description Fannie Mae and Freddie Mac RMBS and CMBS
Investment opportunity RMBS and CMBS issued and/or guaranteed by Fannie Mae or Freddie Mac
Sustainability analysis The government sponsored entities (GSEs) were chartered by Congress with an explicit mandate: "an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return." The GSEs' primary regulator, Federal Housing Finance Agency, sets affordable housing targets for both single family and multifamily origination. For example:
- At least 24% of originations must be from borrowers earning 80% or less of area median income
- At least 6% of originations must be from borrowers earning 50% or less of area median income
Using St. Louis Fed 2017 national household income distribution data puts borrowers at the upper end of these targets in the 45th and 30th income percentiles respectively.
Sustainability Pillar Sustainable Growth
SDG Alignment UN SDG 11 – Sustainable Cities and Communities
Sustainability determination Impact Leader

Disclosure:

Past performance is not indicative of future results. The information contained in this article is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, sector, strategy or investment product. The article contains the current opinions of the firm and is accurate as of the date of the article. Such opinions are subject to change without notice. The firm is under no obligation, expressed or implied, to update the material contained herein.

All investments contain risk and may lose value. Socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised by any company of Aegon Asset Management will reflect the beliefs or values of any one particular investor. There is no guarantee that socially responsible investing (SRI) products or strategies will produce returns similar to traditional investments.
Specific sectors mentioned do not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable.

Structured Finance assets (such as ABS, RMBS, CMBS and CLOs) are complex instruments and may not be suitable for all investors. The assets may be exposed to risks such as interest rate, credit, liquidity, issuer, servicer, underlying collateral, prepayment, extension and default risk. Investors typically receive both interest and principal payments for a security and these prepayments may reduce the interest received and shorten the life of the security. Although some types of structured finance securities may be generally supported by a form of government or private guarantee, there is no assurance that guarantors will meet their obligations.

This article contains forward-looking statements which are based on the firm's beliefs, as well as on a number of assumptions concerning future events, based on information currently available, and are subject to change without notice. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein.

Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group. ©2019 Aegon Asset Management US. Ad Trax: 2758635.1 Exp Date: 9/30/2020.

Jose Pluto

About Jose Pluto

Jose Pluto, CFA, is a senior structured finance analyst responsible for providing ABS research, underwriting and analytical support as well as overseeing mortgage credit research. He also serves on the Portfolio Management team for the Sustainable Fixed Income strategy and is a member of the Sustainable Investment Committee.