reen, social, sustainability and sustainability-linked bond issuance is set to reach between $900bn-$1trn in 2023, up from $850bn in 2022*.
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For professional, institutional and accredited investors only. Capital at risk. The views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. This material and its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. While any third-party data used is considered reliable, its accuracy is not guaranteed. This commentary is provided for informational purposes only and should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to sell or the solicitation of an offer to purchase shares or other securities. Holdings vary and there is no guarantee that a portfolio has held or will continue hold any of the securities listed. Wellington assumes no duty to update any information in this material in the event that such information changes. In the UK, issued Wellington Management International Limited (WMIL), a firm authorised and regulated by the Financial Conduct Authority (Reference number: 208573). In Europe (ex. UK and Switzerland), issued by Wellington Management Europe GmbH which is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin). ©2023 Wellington Management. All rights reserved. As of 01 January 2023.
A surprise? Surely not. Given the significant role fixed income plays in refinancing companies globally, sustainable bonds hold the potential to steer capital flows towards initiatives that drive the biggest and best environmental and societal change. At Federated Hermes, this positive transformation is integral to its fixed income funds.
This guide explores how the firm’s fund managers are balancing the need for returns with making a positive impact on the planet in three core funds: SDG Engagement High Yield Credit, Climate Change High Yield Credit and Sustainable Global Investment Grade Credit. The managers reveal how they identify the future leaders of sustainable change, and how they deal with the challenge of finding opportunities within the carbon-intensive-dominated area of investment grade. Their view is that financial returns and sustainable outcomes must be aligned if they are to achieve success in both areas.
For professional investors only
How credit is revolutionising sustainable investing
A Deeper Impact
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Yielding results: The impact of bondholder engagement
Chapter 2
Are we still on track for a recession?
Chapter 5
Is fixed income a fast track or a hinderance to net zero?
Chapter 3
Returns versus impact: A zero-sum game?
Chapter 1
Read the first article
Or browse the other chapters
*Source: S&P Global; ‘Key sustainability trends that will drive decision-making in 2023’ January 2023
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Investing in credible laggards to find future leaders
Chapter 4
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This is a marketing communication for professional investors only. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. These strategies have environmental and/or social characteristics and so may perform differently to other strategies, as its exposures reflect its sustainability criteria. Issued and approved by Hermes Fund Managers Ireland Limited (“HFMIL”)
which is authorised and regulated by the Central Bank of Ireland. Registered address: 7/8 Upper Mount Street, Dublin 2, Ireland, DO2 FT59. Distributed in Singapore by Hermes GPE (Singapore) Pte Ltd which is regulated by the Monetary Authority of Singapore. Distributed in Australia by distributed by Federated Investors Australia Services Pty Ltd. (FIAS) which holds an Australian Financial Services Licence (No. 433831).
In equities you can own the shares of a company and be over or underweight. It’s a bit one dimensional. That same view in credit can be expressed in different ways because there are multiple ways to access a company via credit. The additional information provided by ESG analysis allows for more precision in the amount of risk contribution we want to deploy in a name. And the various ways to access a company’s debt capital structure allows us to express that precision because each of those entry points into a name has a different risk profile, for example: front end versus long end of credit curves; top of the capital structure versus bottom; or even bond versus loan versus CDS. All of this additional information allows you to invest in a more precise way.
Mitch Reznick, CFA
“We want to deliver both financial returns to investors and sustainability returns to the environment and society”
Mitch Reznick, CFA, Head of Sustainable Fixed Income, on balancing returns and sustainability without consistent data, goals, or impact measurements
Head of Sustainable Fixed Income
Both have a connection to social and environmental factors. In the case of ESG integration we are looking at how social and environmental factors affect the financial strength of a company, its cashflows, and therefore its credit risk. Beyond these factors, it is sustainable investing. Here, we want to understand to what extent companies are affecting the social and environmental factors out in the wider world. In some ways the latter has a more purposeful focus.
Why is credit an ideal asset class when it comes to ESG integration?
How does ESG integration differ from sustainable investing?
Well, in these dual-objective funds, we are looking to deliver both financial returns to investors and sustainability returns to the environment and society, which ultimately serves to de-risk the economic system. In the case of the Sustainable Investment Grade Fund, for example, there is a high degree of exclusions or a focus on sustainable leaders. These companies are at the vanguard of sustainability - governance, operations, and/or products - which we believe creates very resilient companies through structural change. On the other hand, there are other thematic approaches like in our SDG Engagement High Yield Credit Fund, where the focus is specifically on transition stories; from laggards to leaders, with engagement as a key catalyst for change in an underserved engagement market (high yield). With SDG High Yield, there are few exclusions because we screen for those transition stories, sometimes in difficult sectors that other sustainability funds might simply exclude. We believe there is alpha generation attached to those stories as these laggards turn into leaders in an economy that is being governed by structural change and a tilt towards sustainability. Along the same lines, you can go further into the thematic perspective in a fund like our Climate Change High Yield Fund, where the focus is on low carbon only. Whilst sustainable credentials are important here, there is an elevated focus on the climate change transition and how changes are being implemented.
How does this style of analysis affect investment decisions within sustainable fixed income?
Investing in sustainability is not a zero-sum game where investors choose between returns and impact. When you attach a sustainable objective to a financial objective, the two should be presented on an equal footing – sustainability is analysed alongside credit risk and valuations. It is true that the more niche you go in terms of the strategy, the investible universe shrinks and therefore tracking error versus a standard benchmark goes up, rendering standard benchmarks a little less relevant. In these circumstances, our own scoring models are more important to assess the right investments.
How do you balance the drive for returns with impact within these strategies?
We have decades - if not centuries - of analysing companies from a financial perspective, but sustainability investing is relatively new. There is no panacea when it comes to analysis, and so finding impact measurements and KPIs that are relevant from a sustainability point of view is a challenge. In addition, there are complexities in creating sustainability outcomes. For example, when solving one sustainability challenge in a business it could create the unintended consequence of creating a new sustainability challenge. Simple example…shutting down the coal mine to address climate change, if not done the right way, can lead to social stress. The point is, sustainability is complex because the SDGs don't always speak to each other; they may be in conflict with one another, so the challenge is to find solutions that reduce this tension as much as possible. For that, you may need governments to step in. Another challenge lies in the culture of sustainable data, where information varies by region as well as by sub-asset class. This is despite the fact we have global notional benchmarks that don't move - 1.5°C is 1.5°C. How do you assess a small company in an emerging market versus a very large US company against this metric? We believe a principles-based approach responds to the idiosyncrasies of region and asset class. And this is where engagement becomes critical - speaking with companies in a consistent, credible way. Our responsibility is to understand what the right set of objectives is; how the impact goals you set for a company may work. They will vary, but it is why we have seven dedicated sustainable fixed income analysts and engagers across our global business. This is necessarily a qualitative exercise.
What are the challenges of assessing the sustainable credentials of a company?
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Returns versus impact: A zero-sum
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Find the right combination
Secret weapon
Fund manager engagement plays a crucial, and in some cases transformative, role in shaping how companies prioritise and implement sustainability. When successful, engagement has been proven to support outperformance, with research indicating that companies undergoing positive change can generate an additional 7.1% in additional annualised returns . At the heart of Federated Hermes' engagement strategy lies the EOS team – a stewardship service provider overseeing more than $1.4tn in assets under advice . This team facilitates corporate engagement and proxy voting advisory services, operating with a long-term perspective to yield positive outcomes for investors as well as society and the environment. 69% of our relationships with companies in our core engagement programme have lasted eight years or more. The fixed income team has woven that EOS expertise into the investment team by embedding dedicated engagement professionals.
Jake Goodman, CFA, Lead Engager, Fixed Income, on how persistent engagement from fund managers is instigating real sustainable change in even the most challenging sectors
Jake Goodman, Lead Engager for the fixed income team, describes EOS as the “secret weapon” that fuels engagement discussions within fixed income. This is of little surprise given the team is drawing from EOS’ almost two decades of intellectual capital and established processes: “When we engage as a fixed income team, we are building on what EOS has already done across fixed income and equities. For some companies there is a history of engagement stretching back over a decade.” EOS encompasses a team of sector and ESG specialists that enables an informed and collaborative approach to company engagement. This shared expertise transforms engagement into a more impactful endeavour, positioning Federated Hermes as an influential investor and ensuring a dialogue that companies cannot afford to ignore. “Combining our efforts with EOS increases our clout hugely because engagement is about influence. And more dollars invested or under advice tends to mean more influence. As an engager, it means I’m talking to a company on behalf of a greater slice of its capital structure, and this often takes us from the millions invested in a company by our own credit funds, to billions invested by total EOS clients.”
Stat box 290 Live engagement objectives in fixed income at 121 companies 3 dedicated fixed income engagers supported by 21 engagers in EOS 50% Approximate AUM in sustainable-themed funds Source: Federated Hermes As at: 30.06.2023 [Ends]
Measuring sustainability
Within the fixed income team, engagement begins with a proprietary SDG (Sustainable Development Goals) score. It is the team’s ex-ante view on the impact potential of each investment and the expected progress that can be achieved through engagement. The scores guide investment decisions, enabling the portfolio managers to tailor strategies based on fund objectives. For example, issuers scoring 1 or 2 are overweighted in the SDG Engagement High Yield Fund, providing credit and value assessments are also strong. Whereas those receiving the lowest score of 5 are excluded entirely. Crucially, the SDG score is independent of the financial research. Goodman explains: “There is a very strong argument for engagement today. We want to invest in companies that see value-creation in protecting the planet and providing sustainable products and services. Our research process is ‘company first’, which means we focus on building the engagement relationship with a company, then leverage that to engage on multiple sustainability topics in parallel.” To highlight the importance of ESG, Goodman works closely with credit analysts to offer a coordinated approach to all company engagement. This collaborative effort means companies experience first-hand that sustainability is not treated as a side endeavour but is in fact an integral component of the team’s entire investment process.
Patience and persistence
This is also what helps the team identify the future ‘sustainable leaders’ within fixed income. This includes companies in the early stages of their sustainability journey, or those within private markets which rely heavily on the bond markets for financing and, therefore, make good targets for engagement. Whilst traditional screening processes may exclude these companies from the investable universe, Federated Hermes believes engagement can be a catalyst for converting the potential for change to realised change. That requires patience, persistence and a long-term view. “It can take years to establish meaningful communication with companies,” says Goodman.
290
Live engagement objectives in fixed income at 121 companies
121
companies
3
Dedicated fixed income engagers supported by 28 engagers in EOS
50
Approximate AUM in sustainable-themed funds
%
Source: Federated Hermes As at: 30.06.2023
Engagement success
Persistent engagement can catalyse real change in even the most challenging sectors. Goodman initiated engagement with a Brazilian steel company in mid-2020. At the time, it lacked concrete sustainability targets, but the company was on the cusp of a pivotal realisation – that sustainability was not merely about paper recycling and changing lightbulbs, but held commercial merit. “Our initial conversations laid the foundations for more in-depth dialogues until the company acknowledged the need for a climate change target. We continued to apply pressure on them, and it wasn’t until mid-2022 that it took the crucial step to set an emissions reduction target.” “Initially moderately ambitious, we are pushing for the company to have its targets assessed against the goals of the Paris Agreement. The next phase of our engagement will involve monitoring and tracking the company’s progress.”
Sources: 1.'Active Ownership,' published in The Review of Financial Studies, 2015 Past performance is not a guarantee or a reliable indicator of future results. 2. As at 31 December 2022
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Fund manager engagement plays a crucial, and in some cases transformative, role in shaping how companies prioritise and implement sustainability. When successful, engagement has been proven to support outperformance, with research indicating that companies undergoing positive change can generate an additional 7.1% in additional annualised returns*. At the heart of Federated Hermes engagement strategy lies the EOS team – a stewardship service provider overseeing more than $1.3trn in assets. This team facilitates corporate engagement and proxy voting services, operating with a long-term perspective to yield positive outcomes for investors as well as society and the environment too. More than half of its engagements are now more than nine years in duration. The fixed income team has woven that EOS expertise into the investment team by embedding dedicated engagement professionals.
What does real manager influence look like in bonds?
Lead Engager, Fixed Income
Jake Goodman,CFA
“We focus on building the engagement relationship and leverage that to engage on multiple sustainability topics in parallel”
Mitch Reznick
CFA Head of Sustainable Fixed Income
Federated Hermes and sustainable bonds
1
2
Most of the global corporate credit issuer base, particularly those of investment grade quality, are a resilient and reliable investment option in uncertain market conditions. The sector may also be one of the best placed to navigate the transition to net zero. With robust balance sheets and diverse earnings streams, investment grade issuers are well placed to embrace the net zero transition; their commitment to sustainability is often extended over a long period of time, enabling them to invest in sustainable initiatives. “Investment grade issuers have access to a robust engagement process,” explains Fraser Lundie, Head of Fixed Income, Public Markets. “There tend to be good governance frameworks in place, the impact of their decarbonisation strategy is often substantial, and they are openly engaging in detailed discussions with a variety of investors like us.” Lundie further emphasises the fact their decarbonisation actions can significantly impact the industry landscape and inspire smaller players to embark on similar journeys. “Getting investment grade companies to change is hugely impactful given their size, scope, and scale. These companies often return to borrow money frequently, and so engagement between us is fruitful because there is an acute understanding of debt capital markets being their lifeblood and us as investors a crucial element. “Having these frequent interactions allows our engagements to focus on what has been delivered on over a longer-period of time and help move towards their target goals.”
Fraser Lundie, CFA, Head of Fixed Income, Public Markets, on why carbon intensive companies can be impactful – and even help accelerate – the transition to net zero
Dirty credit?
Whilst harbouring the ability to foster change on a large scale, the credit sector is also made up of ‘dirtier’ and more carbon-intensive businesses. This is particularly true at the lower end of the market in the high yield space, which has a significant exposure to high polluting cyclical and industrial areas of the economy. Even investment grade has more than its fair share of heavy industry sectors such as energy, automobiles, and steel and cement, for example. Defensive exposures in these sectors are where fixed income investors are today seeking yield. For Federated Hermes, positioning in these larger, higher quality companies that issue liquid bonds is of paramount importance as they are better positioned to weather market conditions that typically follow the slower economic growth seen to date. “It is quite remarkable that lower quality credit has performed as well as it has; CCC-rated credit in the US is up circa 12%. But with tighter credit conditions and growth concerns growing more prominent in China, we see this likely to start causing stresses to appear in lower-quality parts of the credit markets, and so we believe that trend is now over,” explains Lundie. “We are likely to see the shift from inflation concerns to growth concerns take over. It is no surprise we are therefore attaching ourselves to higher quality companies; defensive businesses that have the robust balance sheets and earning profiles.”
Winners and losers
Avoiding carbon intensive sectors is not an option for investors; especially as many of these businesses are essential to sustainable change as the pace of the transition to a net zero world increases. Therefore, the challenge lies in finding financially strong companies that are prioritising sustainability and value creation. “Over the medium and long-term, there will be winners and losers through this transition to net zero; and we see our ability to engage with companies in these sectors as an opportunity,” says Lundie. “Being able to opine and attach ourselves to the winners that are helping to accelerate the transition will bear more fruit for investors as well as the environment and people too. That is true even if currently they are only starting to make changes.”
Take the group’s Climate Change High Yield Fund which invests in the global high yield market but specifically in companies that are able and willing to make the world a better place and tackle climate change. The managers use their model to measure the decarbonisation efforts of a business, with any bond not contributing to the climate change transition not included in the portfolio. But by using a consistent process for initial engagement, the managers hone the analysis on areas of interest to this strategy. “These questions are entirely relevant to every credit strategy we have on the platform because they are inherently linked to a company’s long-term viability.”
Consistent opportunity identification
The first question explores engagement readiness – how receptive is a company to discussions about ESG and sustainability factors? Is a company willing to be proactive in addressing concerns in these areas?
Engagement readiness
Federated Hermes' engagement process is as consistent as possible so that it can be used alongside a proprietary scoring model for any strategy within the fixed income sector. “What we are trying to do from a sustainability perspective, is answer three questions that we believe are absolutely relevant regardless of what strategy the bonds end up in,” Lundie says.
Secondly, the group looks at sustainable leadership – to what extent does a company demonstrate leadership in sustainability within its industry and peer group?
Sustainable leadership
Finally, the group is interested in the company’s decarbonisation commitment – how ambitious, credible, and serious is a company about its plans?
Decarbonisation
Head of Fixed Income, Public Markets
Fraser Lundie, CFA
“Getting investment grade companies to change is hugely impactful given their size, scope, and scale”
Jake Goodman
CFA, Lead Engager, Fixed Income
The transformation required to address global sustainability challenges means a seismic change is needed in the way companies operate. It is one of the reasons that alongside financial outcomes, investors like Federated Hermes are demanding sustainable outcomes too. But with no uniform output, expectations of sustainable impact is varied. For example, in some global regions, investors want to focus on carbon or climate action. In others there is a much larger focus on social or governance impact. With fund buyers’ expectations widely differing, there is a growing need for more niche or bespoke investment products. It is perhaps for this reason that fixed income is becoming a more compelling asset class for sustainability-focused investors, especially as the offering grows and becomes more nuanced over the next three to five years, according to Nachu Chockalingam. In sub-sectors such as high yield the opportunity for growth and impact is even higher, she notes, and fund managers can look for and assist companies beginning to implement a sustainable agenda.
Working with companies at the beginning of their sustainable journey allows managers like Nachu Chockalingam and Orla Garvey, both Senior Credit Portfolio Managers, to lend a guiding hand for long-lasting impact
Guiding management
“High yield is extremely under-engaged when compared to investment grade for example, as companies have less advanced sustainability strategies. This presents us with an opportunity to identify companies willing and able to change their operations to generate benefits for society and the environment.” She admits many of the companies in this space are not always focused on articulating positive change imminently. However, the group’s focus on engagement allows them to help guide the company on their sustainable journey. “This is also where we as managers can differentiate ourselves from our peers. If you only use third party data to screen investments, that often only reveals one side of the story,” she says, noting data used to analyse high yield companies is often backwards looking and has significant dispersion across different providers.
Future leaders
As Senior Portfolio Manager of the SDG Engagement High Yield Credit Fund, the Climate Change High Yield Credit Fund and the Sustainable Global Investment Grade Fund, Chockalingam believes working with companies at the beginning of their sustainable journey is one of the best starting points to instigating long-term sustainable change. The SDG Engagement HY Credit Fund is managed alongside Head of Sustainable Fixed Income, Mitch Reznick, CFA and Head of Fixed Income, Public Markets, Fraser Lundie, CFA. It targets companies that the managers believe are ‘future leaders’ and will make an impact tomorrow, instead of those making an impact already. The fund is also aligned with the United Nations’ Sustainable Development Goals (SDGs) meaning only those companies that deliver positive societal and environmental returns as measured by the UN SDGs can form a part of the portfolio. Furthermore, the dual objective of providing returns to investors alongside sustainable impact are not seen as being in opposition to one another but interlinked.
SDG alignment
The UN SDGs are an ambitious, universal set of objectives seeking global prosperity and environmental integrity by 2030. The group uses the 17 goals in this fund to assess, measure and articulate change for the issuers that it invests in. To gauge the opportunity for generating SDG-aligned impact, the managers assign an SDG score of between 1 to 5 for each issuer it considers for the portfolio. The score is reviewed and changed in response to business and engagement activity and portfolio holdings and position sizes are adjusted accordingly. “Ultimately, their business lines, supply chains or product and service offerings must provide engagement opportunities to create SDG-aligned impact and their executive teams and boards must be willing to participate in what can be a fairly long term but transformative process,” explains Chockalingam. “We will also need to see progression, otherwise that issuer will be removed from the portfolio. This makes it a very forward-looking portfolio in its approach.” Given the fund’s underlying nature – long-term engagement – the managers anticipate that over time the companies they invest in will be converted from laggards or transition leaders into leaders themselves. This in turn will allow the fund to capture additional alpha, explains Chockalingam, because they will then be screened into leaders funds. Companies must show a willingness and ability to change the way they operate or shift their products or services so that they deliver into the SDGs – which is a great tool to identify, articulate and measure impact. “It is this ongoing engagement with a company that offers a real-time sense of where the company is heading, allowing us to assess if their plans or what they are doing will materialise into credible sustainable impact.”
Engaging businesses early
Chockalingam uses the examples of Suzano, a Brazillian pulp and paper company to emphasise this point. As the world's largest pulp maker, the company has set a carbon-positive target aiming to sequester more carbon than it emits, with a target of net removal of 40 million tonnes of carbon from the atmosphere by 2030 – going ‘beyond net zero’. “The business was very early to the game when thinking about remodelling their business to include sustainability, and have been very engageable with us for a number of years as well allowing us to track their success,” she says. “They took their target and built on it. Today when you think about them in the global context versus their peers, they are by far the most forward-thinking when it comes to sustainability in their sector. With companies like this, it is often starting engagement early that can be one of the key catalysts to them to achieving these goals.”
“Ongoing engagement with a company...allows us to assess if their plans will materialise into credible sustainable impact”
Are we still on track for a recession in 2023?
Senior Credit Portfolio Manager
Nachu Chockalingam
Investment Grade diversification
And what about the current economic outlook? Investors appear set on a soft-landing - a ‘Goldilocks’ scenario - for the global economy, with consensus being that central banks have done enough to cool inflation and should be able to begin cutting rates next year. This outcome, should it arrive, bodes well for the investment grade market and the team’s newest offering, the Sustainable Global Investment Grade Credit Fund, which is co-managed by Nachu Chockalingam and Orla Garvey. Launched earlier this year, the fund aims to deliver a total return in the sector with a reduced environmental footprint relative to the benchmark. “These are not independent goals. We seek to invest in companies that see value-creation in protecting the planet and provide sustainable products and services,” says Garvey. She also believes the global investment grade market offers some of the best opportunities for investors given the diversification on offer; there is somewhere in the region of 18,000 issuers in an opportunity set that extends across 62 countries. This allows for diversification not just across sectors and regions, but also capital structures. While the focus is on investing in established companies recognised as sustainability leaders, Garvey notes they will consider companies that demonstrate a clear momentum in sustainability as well – a theme replicated in the group’s sustainable fund range overall.
Senior Fixed Income Portfolio Manager
Orla Garvey
“We seek to invest in companies that see value-creation in protecting the planet”
This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
