Our views

Credit analysis: Evolution of the ESG approach


Martin Foden, Head of Credit Research

2 November 2018

We believe that whilst ESG evaluation has always been an integral element of high quality credit analysis, truly useful ESG integration has to evolve to remain contemporary. 
Changing environmental risks are a prime example. Environmental developments can lead to new legislation, as we saw recently with the implementation of new energy standards for UK commercial landlords. This is an area where collaboration between our credit and ESG teams and the benefit of issuer engagement has really paid off. While most debt issuers are happy to engage, are well apprised of the legislation and taking proactive steps to mitigate and protect bond collateral values and cashflows, this is not universal. This enhanced insight has improved our understanding of sector and bond risks and, in turn, has helped us assess the additional spread or structural protections we require to compensate for these risks.
Governance analysis remains critical but needs to be relevant. We’ve always considered how management actions may impact bondholders, albeit recognising that bond investors’ scope to influence is less than for equity investors who are the ultimate owners of the business. 
Understanding this control limitation really is the first step to mitigating the risk of management pandering to other stakeholders to the detriment of bondholders. It’s too convenient to assume that management will deliver for shareholders and that bondholders will simply enjoy the ride – corporate history is littered with examples where this has not been the case. Our approach to analysis and building credit portfolios has always focused on addressing this potential misalignment, as well as bondholders’ traditionally weak control once the money has been lent.
We believe that mitigation is the key. Diversification is an obvious element as this reduces the specific risk of individual bond failures. In addition, buying bonds with ring-fenced assets or cashflows, or strong covenants, gives investors greater control and also dampens risk. Ultimately, the better we are at acknowledging, evaluating and managing risk, from whichever direction it comes, the greater the chance we have of delivering high quality and sustainable returns for our clients.
Click here to learn more about RLAM’s ESG approach to credit analysis in the latest Responsibility Matters e-zine.

We believe that whilst ESG evaluation has always been an integral element of high quality credit analysis, truly useful ESG integration has to evolve to remain contemporary. 

Changing environmental risks are a prime example. Environmental developments can lead to new legislation, as we saw recently with the implementation of new energy standards for UK commercial landlords. This is an area where collaboration between our credit and ESG teams and the benefit of issuer engagement has really paid off. While most debt issuers are happy to engage, are well apprised of the legislation and taking proactive steps to mitigate and protect bond collateral values and cashflows, this is not universal. This enhanced insight has improved our understanding of sector and bond risks and, in turn, has helped us assess the additional spread or structural protections we require to compensate for these risks.

Governance analysis remains critical but needs to be relevant. We’ve always considered how management actions may impact bondholders, albeit recognising that bond investors’ scope to influence is less than for equity investors who are the ultimate owners of the business. Understanding this control limitation really is the first step to mitigating the risk of management pandering to other stakeholders to the detriment of bondholders. It’s too convenient to assume that management will deliver for shareholders and that bondholders will simply enjoy the ride – corporate history is littered with examples where this has not been the case. Our approach to analysis and building credit portfolios has always focused on addressing this potential misalignment, as well as bondholders’ traditionally weak control once the money has been lent.

We believe that mitigation is the key. Diversification is an obvious element as this reduces the specific risk of individual bond failures. In addition, buying bonds with ring-fenced assets or cashflows, or strong covenants, gives investors greater control and also dampens risk. Ultimately, the better we are at acknowledging, evaluating and managing risk, from whichever direction it comes, the greater the chance we have of delivering high quality and sustainable returns for our clients.

Click here to learn more about RLAM’s ESG approach to credit analysis in the latest Responsibility Matters e-zine.

Past performance is no guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.