A decision by one of Europe's leading investors to walk away from a conventional euro bond deal from a US real estate company because of its low ESG rating is another significant sign that fund managers are taking an increasingly hard line on issuers that fail to meet the standards required by their ESG policies.
An otherwise mundane transaction for Public Storage in January was notable for the absence of French investor Amundi, Europe's biggest fund manager by assets, because of the company's poor ESG score. Amundi declined to comment on the specifics of the Public Storage transaction.
Public Storage has an ESG rating of Single B from MSCI, its second-lowest rating category. In contrast, the company's credit ratings are A2 from Moody's and A from S&P. Public Storage did not respond to requests for comment.
Amundi's absence did not affect the deal - that the €500m 12-year note was priced 35bp inside initial levels is testament to that - but it underscores the growing importance of an issuer's ESG rating for investors' decision-making.
"We haven't invested in specific deals purely because of low ESG scores even though the pricing was attractive," said Marion Le Morhedec, head of active fixed income, Europe and Asia, at AXA IM. "We are talking about issuers with very low ESG scores where we believe they haven't taken consistent steps to improve."
While a refusal to lend by one or two investors will not derail a new issue at the moment, if more adopt the same attitude borrowers will have something to worry about, especially in tougher markets when every potential credit decision has greater significance.
"The real test of it will be when we go into a downturn and there's a greater dispersion between the 'haves' and the 'have nots'," said Mark Wade, director of research industrials at Allianz Global Investors. "When investor sentiment changes, it can be very painful for companies that haven't got on board with ESG."
In extreme cases, some businesses could go bust, as has been evident in the coal industry. But more likely, vulnerable companies could find their funding options limited.
"There will be money to support out-of-favour businesses and companies but it will come at a cost," said Frazer Ross, head of European DCM flow syndicate at Deutsche Bank.
Last year, Fitch downgraded CoreCivic, a US private prison operator, after a number of banks, including JP Morgan, Bank of America and SunTrust announced plans to stop lending to the company due to ESG concerns as part of a broader pull-back from the sector.
"Increased institutional lender and investor focus on ESG could reduce the company's access to attractively priced public equity and debt capital," said Fitch after cutting the company's rating to BB from BB+ and assigning a negative outlook.
The yield on the company's bonds shot up in the aftermath of Fitch's announcement on July 23. The yield on an October 2022 note, for example, had risen by 50bp by mid-August - to 5.87%.
The bond has subsequently rallied, with the yield now less than 4%, after Nomura syndicated a US$250m five-year term loan B in mid-December to help refinance US$325m of senior bonds that were due in April 2020.
Nomura declined to comment.
The term loan came, however, with an interest rate of 450bp over Libor with a 95 OID and 1% floor. It was also secured by a first priority lien on certain real estate assets, which Moody's said was "evidence of reduced market access within the private prison sector".
CoreCivic called banks' decisions to stop lending to private prisons "politicised". On Fitch's downgrade, a spokesperson told IFR it was "notable that the other two ratings agencies (S&P and Moody's) did not come to the same conclusion. In this instance, Fitch appears to be the outlier rather than the consensus opinion."
MATTER OF TIME
Some believe it is only a matter of time before ESG becomes the most important criteria for investors when assessing new issues.
"The order in terms of priority has traditionally been the credit quality, then the price of credit and then the credibility of the sector. But now, some investors are flipping that, with ESG becoming the priority," said Ross.
In practice, the ESG and credit ratings are often two sides of the same coin.
"Whereas credit ratings primarily assess the risk of default, ESG ratings assess a broader set of extra-financial risks. The two complement each other," said Heather Lang, executive director of sustainable finance solutions at ESG ratings firm Sustainalytics.
And while there may be a moral reason behind why investors shun certain companies or industries, often it is combined with cold, hard economics.
"When you look at E, S, and G factors, they really provide the potential for idiosyncratic risk," said Wade at Allianz. "If you look over recent decades and at how companies failed, it quite often came down to E, S, and G factors. Therefore, from a bondholder perspective, these are extremely important and can provide significant downside to what is an asymmetric outcome of your bond."
A study by Amundi found considerable discrepancy in the performance of euro-denominated investment-grade portfolios focused on the best rated ESG companies and the worst.
Buying the top 20% of euro-denominated bonds ranked by their ESG scores and selling the 20% worst would have generated an annualised performance of 37bp between 2014 and 2019. Social was the best performing pillar.
For US dollar-denominated investment-grade bonds, however, the results are less encouraging - indeed there is a negative relationship between ESG scoring and performance, suggesting a transatlantic divide.
Even so, Eric Brard, head of fixed income at Amundi, said investors need to put ESG criteria at the centre of what they do.
"The time has come to reconsider ESG in bond-picking processes and bond portfolio construction. ESG integration is now a matter of fiduciary duty for both asset managers and asset owners."
Big investors use scores provided by Sustainalytics, MSCI and others - including IFR owner Refinitiv - as a starting point for their own overall credit analysis.
"If we see a low external rating, that's a red flag for us to dig into the topic," said Annemieke Coldeweijer, a portfolio manager at NN Investment Partners. "If our own analysis confirms those concerns it could be a reason not to invest, though we try to engage with the companies first."
NN considers criteria tailored across all three ESG pillars when assessing a potential investment.
For a financial company, for example, its governance might be more important than its environmental impact. With an oil and gas company it might be the other way round.
NN has also invested in technology that applies artificial intelligence to supplement the external data it receives.
At AXA, analysis is a mixture of quantitative and qualitative factors. For its quantitative analysis, AXA has access to 8,200 ESG scores at issuer level and 20,000 scores for individual issues.
For its ESG integrated funds and mandates, AXA applies an internal scoring system from zero to 10, choosing not to invest in any issuer or security that scores less than two.
But the significance of the qualitative analysis should not be underestimated. What matters is identifying the improving or deteriorating trends, not just the ESG score itself.
"If you invest in companies with very high ESG ratings, there may still be scope for improvement," said Le Morhedec. "We are interested in companies that are creating value through improving their ESG credentials.
"The score, therefore, is one thing but the qualitative assessment is very important."
Le Morhedec said that with growing pressure from regulators and clients on asset managers, ESG assessment was now integral to the investment process.
"I'm convinced there is no way back."
Additional reporting by Helene Durand
|Annualised excess credit return in bp (IG, 2014-2019)|
|Long/short strategy||Optimised strategy (tracking error = 25bp)|