Francis Menassa (JAR Capital): Why EU legislation on ESG can enhance high yield returns
By Francis Menassa — Founder of JAR Capital, an independent wealth and asset management firm based in St. James’s
In the last two years investment in sustainable fixed-income assets has been gathering pace. According to a report published by the Global Sustainable Investment Alliance, investing in ESG fixed income now accounts for over a third of responsible investing, an increase of 34% in two years.
Interest in environmental, social and governance (ESG) factors should come as no surprise, however; shifting social norms and evidence of worsening climate conditions are of course major contributing factors to this trend. But an EU law requiring large companies to disclose certain information on the way they operate and manage social and environmental challenges is having particular benefits for high yield fixed income investors.
Creating a framework for responsible business
The EU’s 2014 Non-Financial Reporting Directive requires companies to disclose non-financial and diversity information. The aim is to help investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and encourages these companies to develop a responsible approach to business.
Fully implemented at the end of 2017, this new law requires previously unrated or poorly rated companies to increase transparency when issuing debt. As a result, many companies are now actively working to improve corporate governance and channels of communication while making more efficient use of resources. Ultimately reduction in legal, environmental and reputational risks is opening up more opportunities for sustainable fixed income investment.
Fixed income needs different metrics
Until recently, incorporating ESG factors into fixed income investment analysis, particularly in high yield, has been easier said than done. Unlike the equity space, there have been no ESG credit ratings (ratings agencies had little or no access to ESG information) or sustainability indices against which to benchmark performance. Furthermore, the issuers themselves were unprepared for any ESG concerns from investors in their fundraising process.
Inevitably, investing in the sustainable high yield bond market is higher risk. It involves complex analysis of companies’ opaque debt structures. Meanwhile reporting inconsistencies and gaps in accessible information make it difficult to compare companies. This can result in mispriced risk and in extreme cases, corporate defaults. Parmalat, Enron and Worldcom are just a few examples of where things can go wrong.
The fund managers at JAR Capital are pioneers in the high yield fixed income sustainable sector, always assessing environmental, social and corporate governance factors as an integral part of the decision-making process. In the case of Parmalat, despite their wholesale misleading of the market and many investors, we chose not to invest. By using our proprietary analysis, we could see that there were significant shortcomings in the debt structure.
Active collaboration with issuers
To compensate for the lack of available information, we have developed our own ratings universe, partnering with ISS-oekom, one of the largest independent rating agencies in the sustainable space. Additionally, we now employ ESG experts to enhance our analysis. Our extensive due diligence has meant that we have had no defaults in any of our funds.
The European car industry is a good example of where we have added value. In terms of components, most cars are produced by the suppliers and almost 60% are privately held. Many of the companies that we invest in had no published data and there was very little transparency in their operational structure, yet we found that most complied to sustainable standards. However, no active public engagement meant no sustainability rating which limited their financing options. We offered guidance on sustainability standards, resolving problems and improved their ESG ratings.
Higher standards, more opportunities
The growth of ESG continues and there are signs that the EU directive is beginning to take effect, albeit slowly. A report published in November 2018 by the Climate Disclosure Standards Board found that over a year after the implementation of the EU’s 2014 Non-Financial Reporting Directive companies do not consistently report information. While 99% of the sample of 80 companies representing 3.75 trillion euros in assets disclose their policy approach to at least one key non-financial aspect, less than half described their due diligence processes for climate and environmental risks.
Yet we are now seeing more wide-ranging approaches to high yield debt, both for issuers and investors. Advancements in technology mean that there are more sophisticated methods of data collection and interpretation.
There are also a range of benchmarks to draw from as well as highly regarded sustainability standards, both private and governmental. In March 2019, the European Parliament adopted rules under its Sustainable Finance Action Plan to require asset managers to use a common reporting standard to disclose how they consider ESG factors and to prevent them from greenwashing.
On a private level, the FNG Label, established in 2015 for sustainable mutual funds provides a transparent standard for funds which pursue a consistent and rigorous sustainability strategy.
These major policy developments combined with industry-wide approaches are presenting unique opportunities for genuine responsible investing. Those high yield fixed income funds that can provide ESG and sustainable expertise have the potential to effect positive change while generating improved returns.