Historically, the development of ESG analysis has focused on equities and corporate bonds. As such, there is no agreed or standard approach to ESG investing in the securitized market. However, investors are coming to understand that ESG factors are material and relevant to security analysis, particularly for a space that, at $12 trillion in total size, accounts for over 25% of the total public fixed income market. In a recently published white paper, Thornburg’s experts Jake Walko, Rob Costello and Jeff Klingerhofer explain the way ESG is applied to the securitized market analysis of the company: “The evaluation must focus on financial materiality: determine material factors, understand their disclosures and ESG performance as part of the broader security analysis and use material factors – factors that are both important for the issuer’s financials and decision-making process as well as by reasonable investors- as part of the decision-making process to determine if there is an actual ESG commitment or greenwashing, and therefore purchase or sell a security.
“One of the challenges of incorporating securitized ESG analysis is the degree (or lack thereof) to which issuers provide ESG disclosures. To tackle this challenge, we engage with issuers on a frequent basis to obtain information we feel is material to ESG analysis. We advocate with all issuers to provide as robust and detailed ESG disclosure as possible”, explain Thornburg’s experts. In fact, they point out that this practice “is more important than what can be gleaned from quantitative data only”.
For the fund management company, establishing and maintaining a proprietary ESG securitized framework is more important than wait for an industry standard to evolve. That’s why they have developed an integrated approach, meaning that each investment team member executes on this ESG process. “The benefit of integration is that investment team members consistently apply the process across the analysis of every security. As such, it keeps the professionals, who know their specific markets the best, responsible for ESG analysis”, Walko, Costello and Klingerhofer explain.
ESG Analysis in Securitized – Challenges and Progress
There have been a number of historic challenges to implementing effective ESG analysis in the securitized market. Thornburg’s experts highlight the fact that Issuers provided little or no disclosure of ESG factors that could impact future cash flows. “Indeed, most mortgage and asset-backed issuers were and are small, privately held companies that are not accustomed to providing these disclosures. The exception has been asset-backed issuers that also issue in the corporate market – for example, a large auto company with both secured and unsecured debt outstanding”, they add. Fortunately, investors are beginning to make issuers of all types more aware of the importance of ESG disclosures in analysis. Today, robust disclosures can attract a larger investor base that can lower the cost of capital for issuers, and ultimately, underlying borrowers.
Another challenge to ESG analysis according to Thornburg’s white paper is understanding the cash flow dynamics of hundreds or even thousands of underlying loans. Traditionally, the ESG corporate focus has centered around how management teams evaluate and manage ESG risks and opportunities. Securitized fixed income is unique in that idiosyncratic risk in individual loans is diversified away, necessitating a more holistic focus on how lending and underwriting standards, and broader social factors, impact security cash flow.
“Fortunately, lending and underwriting standards, particularly in the mortgage-backed securities market, improved meaningfully in the years since the global financial crisis. This effectively makes the space more ESG investor friendly”, managers point out.
It is Thornburg’s belief that an effective ESG securitized framework should center on how the lending process itself ties to ESG considerations. At the investment firm, analysts aim to understand the issuer’s underwriting process for the individual’s ability to repay their loans, which can also include influences related to ESG factors. They have directly identified, for each securitized sub-market, the environmental, social and governance factors they consider material to underlying cash flow.
Environmental
Though environmental considerations vary by submarket, a common material factor is assessing how carbon emissions, and further regulation/legislation to reduce emissions, impact cash flow. For example, in auto ABS, they assess potential recovery values (in case of default) of gas vehicles, given the trend toward higher fuel efficiency and expected increased market share of electric vehicles.
Energy and water management are closely associated with commercial properties, therefore impacting the analysis of commercial mortgage-backed securities (CMBS). Newer, energy efficient buildings will be more desirable to tenants, given the reduced likelihood of costly upgrades necessary to comply with new regulation and building codes. This factor translates to favorable cash flow generation as well as higher property values.
Another material factor is heavy geographic concentration. Loan pools with large exposure, for example, to the state of California, are vetted for proximity to potential wildfires and earthquakes. Similarly, exposure in Florida and Texas is analyzed for collateral in hurricane sensitive areas. Of course, it is difficult to assess the precise impact to cash flows as a result of natural disasters for which timing and magnitude is uncertain. However, it’s important to understand geographic concentration as it impacts nearly every type of securitized sub-market, whether cash flows are backed by hard collateral or not.
Social
It can be reasonably argued that social factors have a direct impact, given the underlying loans in many sub-markets go to individual consumers. Therefore the ability (or inability) to repay can have a meaningful effect on human lives. In Thornburg, they believe research into material social factors lies in the analysis of the lending process itself. The goal is to understand issuers’ underwriting processes for its effectiveness in assessing consumers’ ability to repay. Loan structures which make repayment challenging may cause consumer credit impairment that can have financial reverberations for individuals many years following a default. This risk applies both to residential mortgage loans as well as consumer loans (i.e. home improvement) and credit card payments which flow through to asset-backed securities.
Governance
Governance factors are focused primarily on the issuer’s lending and securitization structure, operational considerations, and overall support and disclosure of ESG factors. Issuers with streamlined and centralized credit, funding and collections signal a strong underwriting platform and reduced risk of fraud. In a similar vein, poor securitization reporting increases the risk of weak performance or fraud, which may not be detected quickly.
“To conclude, we believe the analysis of ESG material factors in securitized is essential to a full understanding of risk and return. The ability for managers to incorporate an effective process for ESG analysis in securitized we believe will enhance alpha potential as well as allow allocators to fully understand ESG exposures across their entire investment program”, Thornburg’s experts conclude.
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For Cecilia Prieto