Hello and welcome back to the PH&N Institutional Perspectives podcast, where we discuss interesting and relevant topics for institutional investors. My name is Haley Hopwood, I'm your host. I am a portfolio manager at PH&N Institutional, and it's my pleasure to introduce my guest today, Anna Temple. Anna is a portfolio manager on the PH&N Fixed Income team with a focus on investment grade corporate credit. Welcome, Anna. Thank you so much for joining me.

Hi, Haley. Thanks so much for having me here.

Okay, so today we are going to be discussing ESG and specifically how ESG risk analysis can be integrated into the management of clients’ fixed income portfolios. This is something that Anna dedicates a fair amount of time to, in addition to looking after mandates that have ESG-specific criteria. So let's dive in.

I’m quite sure that all of our listeners have heard about ESG, but just for the sake of completeness, the E, S, and G stand for environment, social, and governance, and ESG integration is typically defined as the ongoing incorporation of material environmental, social, and governance factors into investment decisions, with an aim to improve long-term, risk-adjusted returns.

I think it’s fair to say that there has been significant growth in not only at the awareness of ESG, but also just its prevalence across investment markets, and something that I think can be confusing to people is all of the terminology that’s out there, from ESG integration to ESG investments, impact or thematic investing, exclusion strategies. What does it all mean? So maybe we can start there. And you can help boil that down for us.

Yes, for sure. That's a great question. And maybe the simplest way to really think about it is to visualize kind of a spectrum of integrating ESG considerations into a portfolio. So, for example, on one end, you can have ESG integration. And as you mentioned earlier, it effectively means that ESG risk analysis is present and it is part of overall fundamental research.

So kind of similar to how an analyst would perform any part of their credit work, where they may want to look at relevant sector trends or company operations or leverage metrics, cash flow metrics. They would also want to review the compay’s exposure to environmental, social, and governance risks. And then any material factors of those would then be considered as part of the overall risk/reward decision.

Now, moving along that ESG integration spectrum, some investors may want to take this a step further and actually seek out a mandate that would specifically exclude certain assets or certain sectors. So for ESG screening and exclusion mandates, they may look to prohibit ownership of assets with certain characteristics, or being in fossil fuel or tobacco or gaming or other types of sectors.

And then lastly, you can have thematic mandates. Now these are portfolios that are designed to address a specific ESG issue or invest in ESG themes. So for example, an investor may want to have a portion of their portfolio or their entire portfolio focus on provision of social housing or clean energy infrastructure.

Okay, so screening and thematic strategies clearly are more investor specific. And ESG integration is something that's more broad and applies to traditional strategies. And so I think that's where we'll focus most of our time today, and specifically on ESG integration within traditional fixed income strategies, given that's your area of expertise. So as fixed income investors, our primary concern is whether a company can repay its debts and ESG factors can have an impact on that.

That could be both positive or negative. But there's a lot of noise out there and not everything is relevant. So can you maybe talk about how your team determines which ESG factors are most material to a company's operations?

Yes, definitely. Another great question. And certainly something that we spend a lot of our time thinking about.

Materiality is a key concept that often comes up when we're discussing ESG. And, you know, as you think about it, not all sectors and not all companies have the exact same exposure to specific ESG risks.

So, for example, you can have a telecommunications company and perhaps they have greater exposure to data management or privacy or information security, or fairness of access from their customers, their financial policy or other types of risks. Now, in a different sector, like the power generation sector, you can be more exposed to things like safety, regulatory risks, emissions, or stranded asset risks.

And, within a specific sector, materiality can also vary. For example, governance considerations can actually be significantly different for various issuers within the exact same industry. And your risk assessment on one company can be quite different for another company, even though they operate in the same sector. In our experience, we have found that answering a few questions can be helpful in assessing overall materiality.

So, the first thing that we start with is to say, well, what are the ESG risks that are facing the sector or the industry that the company operates in? And then we'll want to zero in on what are the ESG risks that are specific to the issuer itself. And as I was mentioning earlier, each company is very unique, and the ESG risks may differ from one issuer to another, even though they're in the same sector.

Then we would look at, okay, well, what are the options that are available to the issuer to mitigate both sector-specific and then issuer-specific risks. And then finally, we'll want to ask ourselves: is management's mitigation approach or the actions that they're taking really and  truly improving the long-term viability of the business and kind of future-proofing that business model?

So that last question is very important, and one that we have to keep in mind, even for great management teams, because the issuer's risk-mitigation efforts may not fundamentally change the underlying risks to the business, despite them being strong efforts or being an excellent management team. So, for example, if our concern for a particular issuer is stranded asset risk and management is focusing their efforts on improving ESG reporting, let's say, we would welcome, of course, the improvement in reporting, but we would not feel that management's actions are addressing those most critical, most material concerns that we have about that company. And so in our ESG work, we really try to understand the long-term viability of the company and then what options, if any, are available for management to consider.

Okay, perfect. All of that sounds like it would be applicable for both fixed income and equity investors alike. Are there particular types of ESG risks that you find are more relevant specifically for fixed income investors?

You are correct. And generally speaking, kind of all providers of capital want to see strong operational businesses that run in a very financially prudent manner. So we're on the same page there, but there is an area where I think we could sometimes have kind of differing views from our equity colleagues, and it tends to be on the governance side.

There are actions that can be taken by companies that are can be viewed or deemed to be equity friendly. Some examples of this would be rapid dividend growth or share buybacks, or increase in leverage. But of course, up to a certain point, our equity peers wouldn't want to see debt capital market access shut off for any of their companies either, but for us, we want to see that prudence in balance sheet management, a strong commitment to public ratings and leverage targets, and just overall transparency about a company's key capital priorities. And, if we do see debt issuance, we want it to support overall competitiveness of the business or improvements in the business model, rather than going towards funding shareholder returns. We have also come across instances where you'd have an issuer who tended to get too aggressive with their financial policy and actually, eventually they may also face pressure from their shareholders as well.

I think that's a very interesting and important point. ESG analysis is really not a one-size-fits-all exercise by any means. Okay, so switching gears now just a little bit I know that the PH&N Fixed Income team has long had a view that analysis of any relevant risk, whether it’s ESG or something else, is important to determining a company’s overall sustainability and credit quality and so we forever considered those factors. However, over the years, the team has done a lot of work to refine the process more formally as it pertains to incorporating ESG risk analysis into our investment grade corporate credit research, decision-making, and monitoring. Maybe you can talk a little bit about that and some of the changes that the team has made.

Yeah, you're definitely correct. ESG analysis is not new to us at all; our team has been of the view that being as comprehensive as possible is important in all fundamental credit analysis. And maybe years ago, we may have not necessarily have called it ESG, but the work was still being done. And being thorough in understanding what makes a company tick has always been a key part of our research.

So understanding all material risk, be it, you know, ESG risk or other fundamental type risks, it was always important to us. But in terms of more recently some of the things that we've worked on, I would say that our team has formalized our ESG risk assessment approach and how it's presented as part of our overall credit work and the credit reports that we produce.

We've also developed an internal ESG rating framework for corporate, quasi-government, and government issuers. And these can and certainly do have impact on our overall internal credit ratings. And then we also are very fortunate to work with RBC Global Asset Management's Responsible Investment team. This team does a lot of heavy lifting in following industry trends and regulatory developments, as well as sharing best practices, because they are available to all the investment teams across the RBC GAM platform. And they also help with calculating ESG portfolio metrics.

Some of the other, I would say, notable developments that I probably should highlight as part of this, would be that the market for ESG risk awareness has generally improved tremendously. And, most issuers that we speak to have, you know, developed their own very unique sustainability strategies, or they've started reporting ESG data and some have started issuing labelled bonds.

So, this overall awareness in the market and this understanding and acknowledgment of ESG risks, it has certainly led to more meaningful discussions with companies and something that we take a lot of pride in are our engagement efforts, where we're able to have these open and transparent discussions with management teams about what they are doing to address ESG risks or what they're reporting on the ESG front, their successes or some of the challenges that they're facing.

And there have been cases where we've also been actively involved in direct discussions with issuers about establishing their initial sustainability strategies, or revising them to update them for new developments, or even bringing labelled bonds to market. And maybe lastly, one of the things that we've also done is over the past few years, we've launched a series of funds that have very specific ESG-related constraints that are directly embedded into the investment mandate restrictions.

Okay, thank you. There are a couple of things that you touched on there that I want to expand on, but maybe the first one is this internal ESG ratings framework that you talked about. Do you mind just giving us a little bit more colour on what that is and explaining how it works?

Definitely. We felt that we'd been producing internal credit ratings for a very long time, and we felt that similar to how we produce these internal credit ratings, we should also have a scale for an internal ESG rating.

We could have set the scale at anything, it could have been a 0 to a 10, or a -5 to a 5. We calibrated the scale to be from -1 to a +3. -1 is for higher-ESG-risk issuers, and +3 would typically represent issuers that are engaged in activities that include provision of housing, education, health care, renewable energy, or other types of social or critical infrastructure. And the rating is assigned after doing a very deep dive, into the sector and the issuer, all of their publicly available information and reporting and discussions with credit rating agencies and of course, discussions with the issuer’s management team.

The way in which we assign the rating really kind of goes back to what we were discussing earlier, and some of those questions that we want to ask ourselves, you know, what are the sector risks for ESG? What are the issuer’s ESG risks, and can the issuer meaningfully and materially mitigate such risks?

An example of that could be, if we view a sector to generally have low ESG risk, perhaps an issuer would receive on average a +2 or maybe even a +3 rating -- but because we have material governance concerns for that particular company, we could actually lower that rating to a -1. So the rating does move company dependent and sector dependent.

When we perform our risk analysis, we really try to determine the extent to which ESG risks are mitigated. We're trying to focus on efforts that protect the long-term viability of that business or the structure of that business, because that is what we are ultimately concerned with as bond holders -- is being paid back. So we probably wouldn’t give much credit for overall awareness of the presence of ESG risks or let’s say, very well polished reporting. Now, once we arrive at the ESG risk rating, this rating will then directly feed into our overall internal credit rating and it tends to have impact on the internal credit rating, but at the extremes. So if it’s a very low rating, it could drag down the internal credit rating. Or if it’s a very high rating, it could potentially bump up the internal credit rating.

And maybe I’ll end with that, as bond investors, we could be buying very long-term debt -- we could be buying 30-year bonds. And so we really have to have that solid conviction that the issuer will be able to either repay these bonds or refinance them at maturity.

Okay. Perfect. And a follow-up question to that -- you sort of touched on this a little bit -- but, if an issuer receives that score of -1 would we automatically exclude them? Based on your comments, I think the answer is “no,” but how does it influence our decision to hold? Would we be less likely to hold that name, for instance?

So no, we would not exclude that issuer, but it would be, of course, mandate specific. So, if you have a strategy that explicitly states within its investment mandate that this issuer is not allowed because of the sector, or perhaps a mandate restricts based on a certain ESG rating, then those issuers would be off the table, but for broader mandates that do not have ESG-specific restrictions, it does kind of go back to that risk/reward meaning.

Similar to other fundamental factors, our ESG analysis really considers what the ESG risks are. And if they're being sufficiently mitigated, whether or not we're comfortable having exposure to such risk. And then if we are, are we being compensated enough to actually own that risk. And I think ultimately, we say this to our clients a lot, that our fiduciary responsibility to our clients is to ultimately maximize their investment returns without undue risk of loss.

So unless it is prohibited by the investment mandate, then the mere presence of an ESG risk or any other fundamental risk would not preclude us from owning that particular issue or sector as long as we feel that we are being adequately and attractively compensated for owning that risk in the portfolio.

That makes a lot of sense. Okay, so the next topic I want to dive into is engagement. You mentioned this earlier as something that the team takes a lot of pride in, and I know as a broader firm engagement is something that we believe is very important within responsible investing, as it can help provide an avenue to assess whether an issuer is managing ESG risks effectively, for instance.

How that engagement occurs for equity investors is fairly straightforward because as shareholders, the fund managers can have influence on companies through voting rights and at shareholder meetings. However, for fixed income investors, it's not as obvious. So, how does the corporate credit team engage with management on ESG issues? And then have you guys seen some success through those engagement efforts?

We definitely believe that engagement is a very important tool, as part of our fundamental credit work and as bond holders, we are still critical providers of capital for companies. And while we can't vote proxies, we still have direct access to management to share and discuss our thoughts or any concerns we may have. And as part of our work, we're able to speak to management, whether that be on a regular basis or if a material event occurs. And we've always been able to get quick access to upper levels of management at companies to ask questions or express any feedback that we have. Now, there are many reasons that one would want to engage with management. I think firstly, we will reach out to management during our credit research process or on an ad hoc basis to help us better understand their approach to managing ESG risks as well as other fundamental risks.

During these discussions, we can ask them to, you know, do certain things and to address these risks. And there are many examples of what we've previously asked for. So in the past, we've asked management, for example, to commit to a prudent balance sheet management policy, or to diversify their operations to protect against possible stranded asset risk, or we’ve encouraged companies to pursue additional credit ratings or to work on improving regulatory relations or transparency.

We've also worked closely with companies to develop their labelled bond frameworks. And lastly, we've been fortunate enough to be invited by the issuers themselves to participate on calls or meetings with companies or consultants that they hire to set up their initial sustainability strategies or to update their existing ones for more material issues that may have come up. And we feel that these partnership-style relationships that we've really developed and nurtured over many years with issuers within our investable universe, have been incredibly valuable and we think it gives us a much more thorough and complete understanding of the companies that we ultimately invest in on behalf of our clients.

Yeah, I find it really comforting to hear you talk about engagement. You're clearly passionate about it. And, it just speaks to the quality of the due diligence that you and the team are putting in on behalf of clients.

Just before we end our discussion, there's one more topic I'd like to dive into. It's something that you referred to a couple of times now, which is “labelled bonds.” These are bonds that have specific ESG or sustainability objectives. Years ago, there were just green bonds, and now there's a whole suite of labelled bonds. Can you tell us a little bit about, what those are and the various types?

Yeah. Labelled bonds, they've experienced tremendous growth over the past few years. And maybe just to take a step back, the first Canadian green bond was issued by Export Development Canada, this was back in 2014. Then TD Bank followed shortly thereafter, also in 2014, and they were the first corporation to issue a green bond. And since then we have seen a number of, as you say, labelled bond issuance. We've seen social, sustainable, sustainability-linked bonds -- or SLBs, as they're called. We've seen those come to market. Now in 2023, we saw about $25 billion of Canadian denominated labelled bond issuance. I checked this morning, we're close to $18 billion year to date, and there are about $121 billion of Canadian denominated labelled bonds outstanding, again as of this morning. So maybe I can answer your question in two ways. One is what these actually are. And then how do they fit into our clients’ portfolios.

To start off with what these are, labelled bonds are generally kind of broken down into two types. They are use of proceeds and KPI. For use of proceeds bonds, these are where the proceeds are earmarked and then allocated to eligible projects as per a framework that is publicly available and brought by the issuer. So use of proceeds bonds can be green -- these would be used for renewable energy or other green activities. They can be social – these could be used for social housing or advancement of minority interests. Or they could be sustainable, and this is a mixed use type of proceeds where they could be used for green or social use of proceeds.

The second type of labelled bonds are KPI, and KPI stands for Key Performance Indicator. Now, these are where the proceeds can actually be used for anything, and that includes non-ESG-friendly activities or activities that you may not typically associate as ESG friendly. This is where an issuer actually commits to reaching a certain measurable ESG improvement, and if they don't achieve that improvement they will have to pay a penalty. So SLBs or sustainability-linked bonds are a type of a KPI bond. They can include factors such as improvement in emissions intensity, for example, or diversity representation within leadership or on boards of directors. Now, part of the challenge with these securities, the KPI-style securities, is determining the materiality of those chosen KPIs, and whether or not pursuing to improve those KPIs would actually address the most material ESG risks for that company. And the other issue for those bonds is the calibration of those KPI targets. Are they really ambitious enough?

So that kind of wraps up what they are. In terms of how they fit into investors’ portfolios, I would say that this is a very in-depth subject, and it's a complex subject, and we could probably have a separate podcast on this for another 30 or 40 minutes, but maybe I'll just say that, you know, labelled bonds really should be addressed on a case-by-case basis, and fundamental work should be done whether you’re buying a labelled bond or a conventional bond. But for labelled bonds, it’s also important to consider things like the strength of the framework for use of proceeds allocation, or the suitability for each individual client portfolio, or the actual planned allocation of proceeds -- and we can have these discussions with management as part of their new issue process. Or any potential greenwashing risk, and the presence of a greenium. A greenium is effectively when an investor is being asked to pay more for these bonds relative to the issuer’s conventional bond program. And so we have to ask ourselves if this greenium is actually worth it, if it's there.

Now, a common question we often get with labelled bonds is whether or not they're automatically suitable for mandates that have ESG-specific constraints. And our answer is no. That evaluation has to be done on a case-by-case basis, and one thing to note is we will actually often see some of the most ESG-friendly deals come from the private placement market.

So think about financing a renewable power project, and it's a direct exposure to that asset or a hospital. These don't tend to be issued with a specific ESG label, they actually tend to come conventional or without a label. So, maybe I'll wrap it up by saying that our team has actually put together an introductory primer on the topic of labelled bonds, and maybe our listeners would be interested in taking a look at that.

Okay, perfect. And in addition to that Labelled Bond Primer, our team has also recently released a paper covering ESG integration within investment grade corporate credit. So, if anyone out there wants to learn more about what we've been discussing today, I would encourage you to check both of those out. Anna, thank you so much for taking the time to be on the podcast with us today.

You have such a wealth of knowledge on this subject, and I'm glad that we could share that with our listeners.

Great. Thank you so much for having me.

This content is provided for general information only and does not constitute financial, tax, legal or accounting advice, and should not be relied upon in that regard, neither an institutional nor any of its affiliates accepts any liability for loss or damage arising from use of the information contained in this podcast. In certain instances involving quantitative investment, passive and certain third-party sub-advised strategies, there is no direct engagement with issuers by RBC Global Asset Management.