Credit Rating Agencies are making meaningful progress in identifying and reflecting environmental, social and governance (ESG) risks in the credit rating process. This is both welcome and encouraging, but more needs to be done to ensure the rewards fixed income investors can expect reflect the risks they are taking.
As long-term fixed income investors, one of the fundamental concerns in buying bonds is that an issuing company survives long enough to pay back borrowed capital once its bond matures. The longer it takes for that bond to get to maturity, the greater the chances that factors affecting the risks inherent in the bond will also change.
This creates an interesting challenge for investors: over different time horizons, different factors will affect the creditworthiness of an issuer, and the extent to which they pose a risk will change. Given that backdrop, the question becomes: how do you price risk into an asset when the factors affecting those risks are constantly changing? And how do you do account for the impact of those risks over different time horizons?
ESG in credit ratings – tangible progress
One of the major factors in pricing bond risk is the credit rating that is applied by the Credit Rating Agencies (CRAs). These agencies have been ramping up their coverage of environmental, social and governance related risks in recent years.
The report from the United Nations Principles for Responsible Investment (UN PRI) entitled Shifting Perceptions: ESG, Credit Risk and Ratings, Part 1: The State of Play issued in July 2017 clearly demonstrates that tangible progress is being made to identify and reflect these risks in the credit rating process.
This is welcome news. Fixed income investors do not have the same level of built-in influence that equity investors enjoy in their voting rights. Greater consideration at the ratings stage should mean bonds will be priced in a manner that better reflects the risks investors are exposed to.
A matter of time
However, there are still important shortcomings in how ESG is embedded in the ratings process. In particular, the time horizon over which CRAs assess the impact of these risks is typically shorter than that of long-term bond holders.
The PRI’s report shows the ratings agencies typically look over three to five years for investment grade credit, two years or less for high yield and around 10 years for sovereigns. This puts them at odds with long-term bond investors, whose time horizon is the remaining period to an individual bond’s maturity.
One contributor to the relatively short-term view of the CRAs is their focus on financial factors. This implicitly focuses attention on the short-term as it is difficult to predict future financial performance for most issuers over time frames of more than two years.
However, it is increasingly important that CRAs take a longer-term view and look at a range of different factors for longer-dated bonds. This is particularly pertinent among high-yield bond issuers, many of which are private companies. Not only is there less publically available information relating to high-yield issuers than their investment grade counterparts, their governance standards can also be less robust. Furthermore, by the nature of them being high-yield, these issuers are less likely to be in a position to pay back or refinance the bond or debt when a bond matures. And this is the crux of the issue for long-term bond holders.
A case in point: stranded assets
Take climate change, for example. The issue of ‘stranded assets’ (whereby companies have to write off reserves that may become unviable due to regulatory or economic changes) has become increasingly real in recent years and poses a significantly greater risk today than it did even 10 years ago.
The chances that a coal extraction company finds itself stuck with ‘stranded assets’ on its balance sheet is relatively minimal in the next one or two years. But, expand that time horizon, and the picture is very different. Solar and other renewable technologies continue to improve and fall in price. Meanwhile governments in many developed and emerging markets are coming under growing pressure to address pollution.
The result is a marked shift towards low-carbon energy across the globe. This is highlighted not just by the Paris Accord, but also by initiatives such as the C40 Cities Climate Leadership Group – a collection of 90 cities across developed and emerging markets representing around a quarter of global GDP that are focused on tackling climate change, and reducing greenhouse gas emissions and climate risks.
An investor considering buying a bond issued by a company looking to finance a new coal project therefore has to think very carefully about how to price the risk associated with climate change into the bond. As the time horizon lengthens, the risk of stranded assets increases and the more important that ESG risk becomes. Ultimately, it could end up putting the longevity of the issuer at risk.
CRA’s unique position
CRAs also need to consider their influential position in the fixed income markets. Their influence, access to information and ability to ask highly probing questions of company management early in the process of bond issuance, means they are uniquely positioned to understand how well companies are adapting to long-term risk factors. This is an important aspect of governance.
CRAs’ position and influence also gives them significant powers to push for better standards on ESG issues. This is not a ‘moral obligation’ so much as it is a necessary step in performing credit rating analysis more fully.
By embedding ESG risks more meaningfully at the ratings stage, bonds would be priced more accurately to reflect risk over the duration of the bond’s time to maturity.
Brandywine Global’s Will Vaughan, Global Credit Research Analyst, says: “That would benefit everyone involved – issuers, CRAs and investors – because it leaves less scope for risk to be mispriced in the bond markets.”