Although ongoing macroeconomic and financial conditions have created room for investors to find higher returns from fixed income assets, the recent past has been characterised by such a low yield environment that investors have increasingly ventured down the credit rating spectrum in search of income.
“Combining high levels of income and sustainability has been an appealing solution for our clients in recent years. Given the growth prospects and the size of many of these companies, the opportunity to engage with them and help them navigate the transition is very attractive to investors,” says Christopher Kocinski, CFA, Co-Head of US High Yield & Senior Portfolio Manager at global asset manager Neuberger Berman.
The High Yield Market
Senior Portfolio Manager, Neuberger Berman
“The high yield (HY) market is dominated by developed western countries. It is about 60% US, 20% Europe and only 20% emerging markets (EM). The Neuberger Berman Global High Yield SDG Engagement Fund is about 90% developed markets, 10% EM. Right now, we’re about 60-65% US. Europe is the next largest region and EM is about 10%. Although that fund complies with the EU’s Sustainable Finance Disclosure Regulation (SFDR) and is classified as an Article 8 fund, we also offer more dedicated sustainable solutions along similar classification,” Kocinski explains.
“All of our HY products integrate ESG, and we seek to engage with all of the companies we are invested in. But for other funds, we make an explicit commitment to UN SDG targeted engagement,” he continues. “Interest in funds with sustainable characteristics is predominantly European, but global interest is growing fast. We have three HY funds that have specific sustainability goals, including the Neuberger Berman Global High Yield SDG Engagement Fund, the Neuberger Berman Global High Yield Sustainable Action Fund and the Neuberger Berman Short Duration High Yield Bond Fund, all of which have a dual-focus on income and engagement.”
Two Objectives – Engagement and Income
Discussing what appeals to investors in the sustainable HY fixed income market, Kocinski highlights two factors as dominating. “The most fruitful partnerships we’ve had have been focused on the dual objective of engagement and income generation, without sacrificing one for the other,” Kocinski says. “We are able to achieve this by leveraging our size and access to management. The scale of our traditional non-investment grade credit business and our wider Fixed Income business gives us access to companies’ management teams that a small asset manager just would not have.
When we invest in a HY company we are typically one of the largest bond holders and we are able to get an audience with the senior management of the company, which is very helpful for credit underwriting and to understand a business, but also for access to engage with companies on ESG topics. When we engage with companies on ESG topics, roughly half the time we are talking to the CFO or CEO of the company,” Kocinski argues.
“ESG is integrated at the portfolio management and credit research level. We don’t have a separate team conducting our ESG research. Our senior research analysts already have a dialogue with the CFO, therefore it makes sense to extend that dialogue to incorporate ESG. This way we are able to best leverage our access to senior management. While most asset managers may be able to engage CEOs and CFOs of 15% to 20% of their investment portfolio, we have 50% access because our research analysts have already interacted with the senior management for a significant amount of time. We prefer not to send letters. We focus on authentic senior level engagement,” Kocinski continues.
“Our other critical objective is to reliably generate income for our clients. This is a crucial part of our offering which addresses our clients’ concerns that a lot of the sustainable options available in HY were sacrificing a significant amount of yield. We wanted to create products with a robust engagement platform while maintaining an income level that is competitive with the rest of the market,” adds Kocinski, who is also a member of the firm’s Credit Committee for Non-Investment Grade Credit as well as the ESG Advisory Committee.
ESG Integration and Default Rates
Kocinski believes there are extremely good business reasons for caring about ESG integration. “Prior to becoming a senior portfolio manager, I ran the Non-Investment Grade Credit Research division. In that role, I helped develop our ESG integration process, how we engage and how we track all those activities, in partnership with our ESG investment team. The main lesson I took from that experience as a HY investor is that ESG integration helps avoid defaults,” he explains.
“ESG integration is a critical part of due diligence from a credit underwriting stand point. Six years ago we started to track companies we had avoided for ESG reasons, comparing them to those we had invested in. The default rate of that cohort of companies was approximately three times higher than the broader HY market. The driver of that extraordinarily higher default rate varies by industry and specific circumstances but can generally fit within the parameters identified by a sustainable investment approach,” Kocinski adds.
According to Kocinski, the relationship between ESG assessment and default appears to apply beyond the sample analysed at Neuberger Berman. “The relationship between ESG score and default risk holds in general. Companies that are an outlier to the downside on ESG risks have a higher risk of default overall. But the data in HY is binary. There’s no in-between. If there is an ESG issue but the company is doing well financially, it might not materialise into a default risk. But if the company is already overleveraged, and on top of that there’s an ESG problem, then it could trigger a bankruptcy,” Kocinski says.
“Making sure that one understands how an energy company is handling the climate transition by helping them tackle the ‘E’ in ESG is crucial. But it is also important to distinguish between long-term risks and cyclical effects. For an energy company, the risk of default is also associated with the commodities cycle. When oil and coal prices were low, companies with worse ESG profiles are at a higher risk of defaulting. When the prices of commodities are higher, it would be possible to reach the opposite conclusion,” he explains.
Engagement Targeting and Tracking
Once ESG integration is built, having a dialogue with companies is just a natural extension of this process. “Considering the ESG profile of a company helps identify weaknesses, which can be highlighted to the management team. We have been engaging with companies since our HY business was founded in the late 1990s.
“With time, we’ve become more sophisticated in how we track our engagement with companies. What started out as a culture that focused on having regular catch-ups with a company about anything and everything 20 years ago, has now become a targeted dialogue,” Kocinski adds.
“Over the last decade, we started systematically tracking engagements based on ESG targets, how often they are met, what our goal with that specific company might be, to ensure that we understand and track what progress is being made. We have a scorecard for every company, which was one of the elements I helped develop at Neuberger Berman. The scorecard has customised criteria for ‘E’ and ‘S’ for every industry. However, we apply the same framework for governance (G) for every industry. The ESG integration is part of a credit review document where we talk about the industry, its vices, virtues, valuation, ESG coefficient, etc,” he says.
“We have our own internal data sources and analysis, but we are also informed by third-party data, be it on raw CO2 emissions, external views on how a company should score on governance or other metrics, and ESG ratings. We incorporate these insights into our information set, but we are not bound to their assessment, particularly considering that we have better and more direct access to management,” Kocinski argues.
The Right KPIs
Tracking the ESG journey of companies requires setting key performance indicators (KPIs) that appropriately capture this transformation.
“We try to think about what environmental, social and governance issues are material for a company. We’ll weight E, S and G differently, depending on what industry we are considering. We will often approach a company and warn them that we believe that their ESG risk profile is too high and that we might not be comfortable investing in them. Those are often the type of companies with a default rate three times above the market,” Kocinski explains.
“For our SDG Engagement funds we try to align our funds with at least 12 SDGs, which we group into themes. The process of setting KPIs is a partnership between the research analysts, our engagement team and our ESG investing team. Our research analysts have a dialogue with our ESG experts and they help set the KPIs. Over time it is necessary to show that the engagement is actually bearing fruit and helping you drive change. Without specific criteria set to drive accountability around those engagements, they can become ‘fluff’. KPIs are the only way to overcome this concern,” he continues.
The Power of Fixed Income Investors
“One of the misconceptions in the market is that as a fixed income investor it is impossible to reach management teams, and that they are only available to equity investors. That has not been our experience.
These HY companies are issuing in the market regularly. They value their access to capital and know that they need it ,” Kocinski says.
However, Kocinski argues investors have to be firm. “We don’t think it’s a good idea to invest in high yield rated companies that won’t talk to us. Should a company prove unresponsive or if a dialogue we were expecting does not materialise, we have the option to divest, even though this is not our preferred route. That is what accountability looks like and we have used this tool several times in the past,” he adds.
“If after two years of trying we were unsuccessful, we may move on. It is very uncommon nowadays for companies to be unresponsive on ESG inquiries. These are higher leveraged companies who understand that they are going to need to interact with investors. It’s just common sense for them to engage in a dialogue with investors,” Kocinski argues.
“Anyone can say that they engage with a company, but the value is in being able to prove, transparently that this engagement is taking place and facilitating change and progress, and anchoring our process around these proof points is something that we are proud of,” Kocinski concludes.
Disclamer
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