Responsible Junk: An ESG-Based Approach to High Yield Bond Investing

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On the surface, responsible investing and high yield bonds may appear to have little in common. In an asset class fraught with lower credit ratings, potentially weaker governance models and exposure to less environmentally friendly companies, it might seem that high yield bonds and ESG goals can't coexist. While challenges exist, high yield and responsible investing need not be mutually exclusive. In fact, a research-intensive process can help uncover attractive ESG opportunities in junk bond land to create a best-in-class strategy. In this interview we consulted with Kevin Bakker, Co-Head of High Yield, to understand how investors can pursue ESG-related goals in a high yield strategy.

High yield issuers generally aren't thought of as the most ESG-friendly companies. Further, ESG investing tends to mean different things to various asset managers. What does an ESG-based approach to high yield investing mean to you? And are you simply excluding the bad actors?

You're right – ESG terminology is convoluted and there are multiple flavors of responsible investing. To set the stage for our discussion, at Aegon AM we segment the responsible investing landscape into four main categories: exclusionary, best-in-class, sustainability-themed and impact investments. In addition to dedicated responsible strategies, managers may also integrate ESG factors across their traditional product set as we do.

Exclusionary strategies use negative screening to avoid the bad actors, as you mentioned. That is one approach that high yield managers may use to weed out companies, and even entire sectors or industries, with weak ESG profiles. However, we believe there's more value in allocating capital towards companies with strong or improving ESG profiles. In other words, selecting the "best" high yield companies on an ESG and economic basis. What we find interesting about an ESG-based approach to high yield is that a portfolio can be tilted towards companies with solid ESG profiles while also providing attractive investment opportunities.

But to be clear, we don't view ESG factors in isolation – it's critical to consider the company's financial condition and the economics of the trade cannot be ignored. Incorporating ESG factors can help us better understand investment risk and evaluate if the market is pricing that risk appropriately. After all, we are focused on delivering on our clients' objectives, all of which still focus on competitive performance results at the end of the day.

How to do you tilt towards more favorable ESG profiles? And what differentiates a company with a strong ESG profile from weak one?

To help identify the good and bad ESG profiles, we categorize issuers into five buckets depending on the level of ESG-related risk. Companies with strong ESG profiles tend to have robust governance practices and are finding ways to operate in more environmentally and socially friendly ways. Further, some high yield companies might be leaders in sustainable business practices.

Let's look at a downstream aluminum producer in the metals/mining sector. On the surface, you may wonder how a metals/mining company could be environmentally friendly. But in this case, the producer supplies aluminum to the auto/transport industries, thus supporting the shift toward more fuel efficient vehicles and reducing greenhouse gases. In addition, the company is an industry leader in the sustainable production and recycling of aluminum products.

If we move down the ESG spectrum, companies with improving or low-risk ESG profiles may also be attractive investment candidates. A company may not be an ESG leader today, but they have well-articulated policies in place to mitigate most ESG risks. For example, a homebuilder that is an industry leader in product quality and safety that is also taking advantage of green building opportunities.

In a best-in-class approach, investment candidates must meet our ESG and economic thresholds to be considered for the portfolio.

On the flip side, companies with weak ESG profiles may have high governance concerns or are involved in business practices where environmental or social factors present a material risk to the company's credit fundamentals. Consider an education loan manager and servicer that is fraught with financial product controversies tied to allegedly deceptive business practices in the servicing of student loans. Further, the company has corporate behavior concerns due to lawsuits claiming the company increased customers' debt burdens. In this case, the risk related to social factors has risen to the point where ESG considerations can have a material impact on the company's creditworthiness.

But as we mentioned earlier, ESG factors are just one piece of the puzzle. In a best-in-class approach, investment candidates must meet our ESG and economic thresholds to be considered for the portfolio. To pursue performance-based objectives and responsible investment goals, we cannot focus exclusively on ESG without considering the economic return prospect of the underlying bond.

To conduct this assessment, it seems third-party ESG data would be important. How has the ESG data for high yield companies evolved in recent years?

Availability and accessibility to ESG data has improved greatly in recent years. Research providers cover more issuers and companies are disclosing more ESG-related information. That said, third-party ESG data has limitations as the methodologies are often complex and contradictory. As such, we don't rely solely on third-party data and find the most value in an independent, holistic assessment.

Many times ESG and non-ESG factors, such as traditional financial metrics, are intertwined. To obtain a holistic view of a company's risk/reward profile, we believe it's critical to combine internal viewpoints with external research to formulate a proprietary view on the issuer's ESG profile and creditworthiness. Furthermore, the key to integrating ESG factors into securities research is to focus on ESG factors that are financially material and could affect an issuer's creditworthiness.

Which sectors or industries naturally have low ESG-related risks?

Certain industries do tend to have lower environmental or social risk than others. Examples of certain subsectors with low ESG risk intensity include consumer discretionary, financials, technology, telecom and real estate.

However, in a best in class approach, we believe it's really about looking at what companies are doing to specifically mitigate or alleviate these risks. You can have companies operating in industries historically thought of as 'good ESG' sectors that have significant risks. For example, the pharmaceutical industry. Traditional pharma companies are generally viewed positively for creating important drugs for the betterment of human health. However, the high yield market has several companies that have been under pressure for following a less philanthropic business model. Several high yield issuers have been following a business model of slashing R&D and drastically increasing prices on critical drugs to boost margins. In addition, several of these same issuers are under fire for their role in the opioid crisis, including accusations of knowingly fulfilling fraudulent scripts. Therefore, an industry viewed as having low ESG risk doesn't necessarily translate into all companies within that industry having strong ESG profiles.

Which sectors or industries have weak ESG profiles?

The energy sector is quite controversial from an ESG perspective. Specifically, the independent energy industry is dominated by exploration and production companies where ESG concerns are high. Environmental effects of oil and gas production are numerous, including significant release of carbon and other greenhouse gases. Many issuers also have a history of questionable health and safety practices as well as weak governance issues driven by founding partners and private equity involvement.

...we believe the real value in ESG investing goes beyond basic negative screening to identify companies with better practices or improving ESG profiles.

ESG concerns are also elevated in the metals and mining and chemical industries. With metals and mining, extracting minerals out of the ground involves a myriad of environmental risks related to disturbing the natural environment. Further downstream, smelting these materials into steel and aluminum is highly carbon intensive. From a social perspective, health and safety is a concern given the high rates of injuries and fatalities in the industry. For the chemicals industry, carbon emissions are elevated for upstream petrochemical companies while chemical safety is more of a concern for the downstream specialty chemical names given potential negative health aspects of many products. Increased concerns around the environmental impact of plastics also represents a risk for the chemical industry. Other sectors we view as having weak ESG profiles include those with exposure to social risks, for example tobacco, alcohol or even gaming.

Negative screening can help eliminate the more obvious culprits, but we believe the real value in ESG investing goes beyond basic negative screening to identify companies with better practices or improving ESG profiles. After all, not all companies within a sector are created equal and excluding an entire sector is not a viable solution. With this in mind, we look for companies that have a well-articulated ESG strategy and have solid governance practices. For example, some natural gas producers may have better ESG profiles relative to oil companies. And midstream pipeline companies tend to have more efficient and safer delivery methods than transporting commodities over rail. In addition, a company that produces steel using an electric arc furnace and scrap as an input carries a much smaller environmental footprint than a company producing steel via a blast furnace using iron ore and metallurgical coal as inputs. Or a chemical company producing lithium for use in battery electric vehicles offers significant opportunities in clean technology as opposed to a petrochemical manufacturer that produces polyethylene.

We believe it's important to look beyond the surface-level environmental and social risks and use a best-in-class approach to consider which companies are doing the best job mitigating these risks.

What are the potential limitations of a best-in-class approach to high yield bond investing?

As we've discussed, certain industries inherently have less favorable ESG characteristics. Therefore you could have a persistent bias against certain industries, like energy, particularly if they make up large component of the underlying index.

Likewise, an ESG-based approach to high yield could result in a slight up-in-quality bias. Generally speaking, lower-rated companies, such as those rated CCC or below, tend to have a higher composition of smaller companies and a greater percentage of private equity involvement. Higher private equity involvement tends to lead to weaker governance profiles, all else equal.

Finally, it's important to note that while the focus on stronger ESG profiles may result in a slightly more concentrated portfolio with modestly higher tracking error, ample opportunities remain to build a diversified high yield portfolio.

Let's talk about the elephant in the room – performance. Do you expect that the positive ESG portfolio tilt will affect performance results?


We view ESG factors as a risk management tool and a potential alpha source. For many companies we find that it's quite challenging to analyze the future profitability without considering environmental, social or governance factors. In other words, if we analyzed financial metrics only, we could be ignoring key risks or opportunities that could affect the issuer's creditworthiness or the sustainability of their business model. Studies are now linking poor ESG credentials to higher rates of defaults. A recent study by Bank of America cited that 90% of bankruptcies in the S&P 500 between 2005 and 2015 could have been avoided if environmental and social scores were considered in the five years prior. By integrating ESG factors, we think it's possible to identify risks under the surface that could help mitigate default losses.

Companies that manage their business with environmental, social and governance factors top-of-mind are more likely to have sustainable business models and sustainable cash flows over the long term.

Think about the basics of bond investing. At the end of the day, we are looking for opportunities to generate income plus potential capital appreciation while selecting issuers with the highest likelihood of repaying their debt obligations. If a company's operations are harming the environment and pose a high risk of lawsuits, don't those environmental considerations increase your financial risk? Or let's say a company is engaged in unfair labor practices, doesn't that impact the longer term risks of their business model? How about a situation where corporate governance is poor, doesn't that increase the likelihood of a company running into financial difficulties?

Simply put, we believe ESG factors can affect profitability. Companies that manage their business with environmental, social and governance factors top-of-mind are more likely to have sustainable business models and sustainable cash flows over the long term. From that perspective, we believe companies with better ESG profiles may outperform those with weak ESG practices, resulting in ESG factors being a potential source of long-term alpha.

Disclosure

Past performance is not indicative of future results. This material is to be used for institutional investors and not for any other purpose. This communication is being provided for informational purposes in connection with the marketing and advertising of products and services. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US' ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate. Investors should consult their investment professional prior to making an investment decision. Aegon AM US is not undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.

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.

Investments in high yield bonds may be subject to greater volatility than fixed income alternatives, including loss of principal and interest, as a result of the higher likelihood of default. Value of these securities may also decline when interest rates increase.

This document contains "forward-looking statements" which are based on to the firm's beliefs, as well as on a number of assumptions concerning future events based on information currently available. 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. In addition, this material contains information regarding market outlook, rates of return, market indicators and other statistical information that is not intended and should not be considered an indication of the results of any Aegon AM US-managed portfolio.
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.

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Kevin Bakker

About Kevin Bakker

Kevin Bakker, CFA, is co-head of high yield and a portfolio manager responsible for US and global high yield trading and portfolio management. Prior to his current role, Kevin was a public fixed income research analyst covering high yield and investment grade corporate securities.