This article – ESG Integration Practices In Structured Credit Analysis – is the seventh in a series from the CFA Institute that recaps their ongoing research into the application of Environmental, Social and Governance standards to investment analysis and selection.
The CFA institute is a global think tank with more than 150,000 CFA charterholders globally. The Chartered Financial Analyst® designation is the most respected and recognized investment management designation in the world. The author of this article, Matt Orsagh, CFA, CIPM, is one of a team of analysts studying the practical and policy implications of deploying ESG standards around the world.
by Matt Orsagh, CFA, CIPM, CFA Institute
In addition to bonds issued by governments and companies, the fixed-income market includes securities backed, or collateralized, by a pool of financial assets, such as mort- gages, accounts receivable, or automobile loans. Practitioners are just starting to consider how to systematically integrate ESG factors into structured credit analysis, largely because ESG data coverage is less readily available for some of the transaction parties, including the special purpose vehicles that issue the securities, and the inherent complexity of assessing underlying asset pools that may run into the thousands.
The integration process typically seeks to capture risks at several levels: at the transaction level, relating to the originator/ servicer/issuer of the securities; at the “collateral” or “cover” pool of underlying assets; and sometimes, informing a view on the overall deal structure. Some practitioners give more weight to the originator, others to the credit quality of the underlying asset pool. The approach varies for different types of securitized investments depending on whether the issue is government-backed, and with respect to the overall composition/asset concentration levels of the loan portfolio.
At the transaction level, ESG analysis plays an important role in determining the true risk-adjusted credit profile of a securitization through an understanding of the corporate governance strategy of each of the parties associated with the deal. For example, practitioners may review the lending practices of the financial institutions that are originating the securitization, prioritizing those with clearly stated guidelines for underwriting and a positive record of servicing loans, and avoiding those with predatory practices, poor risk management and regulatory compliance track records, and any conduct failings that could lead to litigation risks and other adverse consequences for loan enforceability.
Strong governance practices cover transparency of management (e.g., publicly-listed companies with audited, detailed financial statement disclosures, whose management team communicates regularly with investors), executive compensation, and board independence (e.g., a diverse board with appropriate controls). Practitioners may also evaluate whether the parties are using securitization as a method of exit or risk transfer, or as a funding source in which they will continue to participate.
At the asset pool, or collateral, level, practitioners consider how ESG factors may affect the financial sustainability of the asset pools, such as auto loans and mortgages. Although the analysis can differ between different asset pools, the objective remains the same—to understand if any ESG risks exist that would inhibit the asset pool from performing as expected, and to accurately value those risks.
Depending on the nature of the collateral, ESG analysis may be given more focus. Consider these examples:
▪ When analyzing securities backed by power assets or power contracts, practitioners may focus on the environmental risk profile of the underlying assets (e.g., the source of power generation).
▪ When analyzing securities backed by commercial or residential properties, practitioners may consider environmental factors on either a specific property or a corporate level, given the increasing impact of environmental regulation faced by property owners in some markets. As such, practitioners can analyze the energy efficiency of a property portfolio in relation to standards such as the UK’s Energy Performance Certificate (EPC) or the US Leadership in Energy & Environmental Design (LEED) certification program.
▪ When analyzing securities backed by auto loans, environmental and governance failings such as the 2015 automotive sector emissions testing deception by a large European automaker are assessed as a material risk to the value of the automobiles in auto loan/lease securitizations.
▪ When analyzing securities backed by general consumer/credit card loans, practi- tioners tend to consider societal risks, such as discriminatory and predatory lending and aggressive and deceptive marketing practices, as material factors.
Quantifying ESG issues in structured credit analysis is limited to the extent that it helps identify securities with mispriced prepayment assumptions, which may trade at a dis- count relative to intrinsic value. For example, servicers that aggressively target borrowers for refinances or servicers that have streamlined procedures for refinances may be avoided, or valued less when bonds are trading at a premium. Qualitative analysis focusing on conducting thorough due diligence of parties to the transaction may ensure no red flags are present among those associated with deals, while looking through the underlying assets may assist with monitoring the performance of the deal for as long as the practitioner is invested in the security.
Many of the practices mentioned in this section have been developed by analysts, portfolio managers, and investors, who share how they integrate ESG into their analysis.
Matt Orsagh, CFA, CIPM, is a director of capital markets policy at CFA Institute where he focuses on corporate governance issues. He was named one of the 2008 “Rising Stars of Corporate Governance” by the Millstein Center for Corporate Governance and Performance at the Yale School of Management.