ESG in High Yield: Three Challenges Facing Managers Today

Gareth Hall: Another thing we're very positive on and we think is hugely important is collaborative engagements across the high yield market. If you think about the things we've discussed already as part of this discussion, you will have noticed that I think everyone in high yield will be suffering from similar lack of data. And going forward, we're going to see a huge amount of demand from ourselves, from our investors, from income and regulation on a global basis around the provision of that data. And what we often hear from our companies that we invest in is, they want to start providing this data, but they are somewhat unclear at this point on what they need to do or what data they need to provide. And they have limited bandwidths in some cases at management level to actually produce all this data. So what we've been doing to give you an example, is where we're part of the European Leveraged Finance Association's, ESG committee. So what we're doing is basically, as part of our initiative, interacting with the companies through round tables and the arrangement banks, the financial sponsors to basically put in place frameworks and fact sheets around what we feel is the investment grade market, we would like to see in terms of base levels disclosure from the company they invest in different sectors on key ESG topics. That's an example of something we've been heavily involved in and is really a great starting point to help companies in the high yield market to begin to disclose data where they haven't done historically.

Greg Campion: That was Gareth Hall, High Yield portfolio manager at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion, and I'd like to welcome you to episode number nine of season four of Streaming Income. All season long we are diving deep into the factors shaping today's markets across asset classes like EM debt, high yield, private credit, real estate and more. Remember, if you'd like to receive our latest insights as soon as they become available, you can follow us by searching Streaming Income on Apple podcasts or Spotify. My guest today is Gareth Hall, a London based portfolio manager on Barings Global high yield team. Gareth has taken on a lead role in the implementation of all things ESG when it comes to high yield at Barings. And as we discussed in the conversation, he's also heavily involved in a number of industry collaborations in this area, including with groups like the European Leveraged Finance Association's, ESG committee, and also the London- based loan market association. So in the conversation we spoke about the ESG challenges that high yield managers like Barings are trying to tackle today. Specifically, we discussed the evolving role that fixed income investors can play when it comes to influencing company behavior, and how it's no longer just an equity investors game in terms of driving such initiatives. We talked about the major challenge that is carbon emissions and how Gareth and team are not only calculating estimates for companies that don't report their emissions, but also engaging with those that they deem to be some of the worst offenders. And finally, we spoke about the broader challenge of data availability and some of the ways that the team is getting around this and how industry collaborations are playing a role. So with that, please enjoy this conversation with Gareth Hall. All right, Gareth Hall, welcome to Streaming Income. Thanks for joining me.

Gareth Hall: A pleasure, and thank you for having me on the show. Great to be here.

Greg Campion: Awesome. I'm excited to have you here first time on the show. We've got a lot to talk about. I know you've been very busy with all that different hats that you wear at Barings on the high yield side and also involved in ESG of course, so maybe let's start there, if you wouldn't mind just describing your role at Barings for us.

Gareth Hall: Sure. So I joined Barings back in 2010 as a credit analyst, and then my role is now a portfolio manager in the global high yield team. And as part of our role over the last few years, I've been heavily involved as our ESG lead in the team, helping to develop our fixed income investment processes and ESG strategy. So as you say, a very busy time in the world of ESG at the moment.

Greg Campion: Absolutely, absolutely. Well, I think we have the right person for the conversation that we are hoping to have, which is specific to ESG and high yield. But I may actually want to start one level up from high yield and just talk about fixed income generally. And I know that there's of course long been this perception, probably this correct perception that fixed income markets have lagged other markets specifically public equities in terms of their implementation of ESG. Now clearly that's changed, and I think every time I talk with you or someone on your team I'm almost astounded to see the progress that's been made. And it's not just a Barings thing, but I think it's probably market wide, but I guess maybe high level, from your perspective given everything that you've seen over the years, was there a step change moment in fixed income markets when they finally woke up to ESG?

Gareth Hall: I think you're exactly right. I think there has been a misconception that fixed income can do less on the ESG front and I personally think that's incorrect as you seem to point out. I don't think there was a particular step change moment, but I think it's fair to say over the last three to five years, we've seen a huge acceleration in take up and analysis within the fixed income market which everyone will have seen across this asset class.

Greg Campion: Yeah. And it's really been incredible just to observe the momentum in this space, so let's zoom into high yield, which is of course your area of expertise. For our listeners, if you haven't seen it yet Gareth, recently penned a piece called, ESG: Three Challenges High Yield Managers are Tackling Today. And I really like the framework laid out in that piece and I'd actually like to use that as kind of, to help us frame up our discussion here today. So let's go through some of those challenges that you laid out in the paper. And maybe let's start with the first one. So you talked about one of the challenges being influencing ESG practices, as you've just alluded to, and how that's different for debt holders versus equity holders. So tell me a little bit from the perspective of a high yield manager about why that is a challenge and then maybe what you're doing about it?

Gareth Hall: Sure. So I think, I guess by way of background people feel that often in high yield because we don't own voting shares and we don't have typically members on the board to help control strategy, that therefore it's more difficult for high yield to engage and to undertake ESG analysis with the companies they invest in. I think that perception as we pointed out earlier has changed now, and I think if you think about why we feel we can engage and we can work on ESG analysis with the companies we invest in, there's a number of strong reasons why we can and we should. So if you think about the typical company we invest in, obviously they will have quite a large part of their cap structure will be made to per debts and as Barings, we're often materially sized lenders in that capital structure. That in itself gives us excellent access to a company senior management, to the financial sponsors who own many of the companies in the high yield market. So it really allows us to engage with those management teams and owners, but also to undertake a lot more detailed diligence on key commercial sustainability risks with those companies as part of the primary investment process or the ongoing monitoring process for those companies. So we feel on the back of that, there is genuine ability for us to influence behavior of those companies and also to request particular data. That being said, and I'm sure we'll go on to talk about it, but obviously the level of data availability for companies within the high- yield market remains inaudible, and you will see in investment grade or in listed equities, for example, by nature of the reporting requirements or say the size and type of ownership of those companies.

Greg Campion: Yeah. I mean, that's interesting that I think as you've alluded to the size of your position in the capital structure can be very material, so I imagine that has an impact on your level of influence with companies. Tell me a little bit about this idea of engagement, and maybe relative to another strategy which is exclusion. And then I'm interested in hearing about how this actually plays out in the real world, so if you have an example or two handy, that would be great to hear?

Gareth Hall: Sure. So, from a engagement versus exclusion debate, I think there are times certainly and during our investment process when we will exclude a specific company from our buyer list, which effectively means we're unable to invest in that company, because we view the ESG risks as too material. That's certainly an important part of our underwriting process that we undertake. But, once a company is approved onto our buyer list, I think it's critical that you engage to improve those companies. And we look at one, the current state of those companies in terms of how they sit today, but also the momentum and the change at as companies that we're seeing, whether that's driven by our engagement or the company's strategy. That's as you mentioned, a very important part of our philosophy at Barings is around engagement, as opposed to just exclusion. In terms of the way we're set up, in terms of our team, we have a large number of analysts sat in Europe and in the US so we have the ability and the time to undertake our detailed analysis on each of the companies. And also that really feeds into our engagement strategy as well in that the analyst teams have had the time and the connections with those companies and owners to be able to talk to the management teams on key topics. And we mentioned being the large lenders in the cap structure as well, which generally gives us very good access to those companies. I mean, to give you an example of something we saw this week, actually, which is very timely. So we have an investment in a soft drinks bottling company, which is global in nature, a very large business. From a ESG analysis perspective, we've had a poor internal ESG rating on that company for a number of courses, given the risks we associate with the high level of a single use packaging and also unhealthy product mix there. That's been one of the companies that we as a team have been engaging on, inaudible discussions with CFO and CEO of those companies to really push them on improvements in those key ESG risk areas. What we actually saw this week through the company's reporting, so they've released results says that they've now got specific new initiatives around development to PEF, recycled packaging, and also doing a lot of work on the sustainability of their raw materials, sourcing relationships, down a supply cycle. So that really has come around over the last couple of quarters and is now a key part of what they're talking about on their, through their presentations and through their reporting. Which is for us very rewarding because, something we've been pushing them to do more. Obviously others in the market will have been doing similar things as well. So, those types of examples where we are genuinely starting to see tangible evidence of improved behavior to companies around some of these topics and in environmental social or governance areas. Obviously we have many more engagements, which are a work in progress or have been unsuccessful, but definitely a mix in terms of success on that front.

Greg Campion: Yeah. That is really interesting for me to hear about, because I think that there's this typical idea that it's in terms of influencing company behaviors, that's very much more an equity story than it is a debt story. But again, I guess to the point where if you're a significant enough part of the capital structure on the debt side, it seems like there are increasingly real- world examples of being able to influence a company's behavior, so that's encouraging to hear. Gareth, I just want to talk to you about the second challenge here, which you laid out in the paper, and that is carbon emissions. And this is obviously such a major focus for investors as they look to mitigate the impact on the environment from their investments. So again, I'm hoping you can explain just a little bit about why this is a challenge again, specifically for high yield managers, and then also tell us what you and the team are doing today to try to tackle this challenge?

Gareth Hall: Sure. And I think as you pointed out, a huge area of interest and we are receiving a lot of positive feedback and a lot of interaction with our investor base on this topic. And certainly something we're working very heavily internally to develop in terms of with our quantitative teams around how we improve the processes and the analytics around carbon, having made what I feel is a good start so far. So just to give you a good bit of background on I guess, the difficulties with analyzing carbon in the high yield space. The reality is that if you're looking at a high yield bonds universe or leveraged loan universe within the sub investment grade space, you will be lacking data. So, lots of companies given they're private ownership or the nature of the businesses don't yet report good quality emissions data and have associated emissions targets, so that-

Greg Campion: I imagine that's pretty different from public market equities, for instance.

Gareth Hall: Exactly, very different to large cap equities, where you have near universal coverage. To give you data points, if we look at a European leveraged loan portfolio, often we're thinking about 20% of those companies will have actual data on emissions. So, somewhat challenged from as a starting point and that will definitely improve over time and there's various reasons why that will improve, but engagements, income and regulation and just general movements in terms the market in that direction. But ultimately that leaves us somewhat challenged in analyzing overall emissions analysis or intensity for individual portfolios. So as you pointed out, what have we tried to do to address that? So what we've developed internally is a reporting process whereby, where actual data is available, we'll take that data from the companies. We aim to supplement that data with direct engagement for disclosure, with the companies to try and get some additional data, but where the data is unavailable, what we're looking at is a methodology whereby we estimate inaudible missions that that company could be based on similar companies in sectors and geographies? That's not a bullet proof way of doing this analysis by any means, but what that allows us to do then is to take all that data and to aggregate it on a portfolio level, into portfolio reporting. And then it allows us to do two things. We use it to engage as in, to focus our engagement strategy. So we look at companies where we feel they will have a high level of emissions, but they don't disclose actual data. And there are companies where we're focusing our engagement, because they're the companies we feel is most important they report that data. And then secondly, on a portfolio level basis, we can consider which companies we own in the portfolios, which have high carbon emissions or high estimated carbon emissions. And then we can think about how we weight those positions relative to relative value for the whole portfolio to start thinking really about building in that analysis into portfolio positioning.

Greg Campion: Yeah, that's really fascinating. It seems like you and the team have been really creative in this regard, because that is, as you were talking about upfront, that's a huge gap to make up with 80% or thereabouts, you don't have data for. So it's interesting to me to hear about how you're triangulating into an estimate of what those emissions could be. One question I have for you on that is you mentioned that this is informing your engagement strategy, is the right way to think about it that you've got essentially it would be impossible to engage with every single company, just from a pure time and resource standpoint. And you need to decide where to allocate those resources where they will be most impactful, and I'm guessing there's probably like everywhere else in the world an 80-20 rule, where you've got probably 20% of your companies in your universe or in your portfolio are responsible for 80% of the issue. I mean, is that broadly or directionally how you're thinking about it?

Gareth Hall: Yeah, I think directionally that's correct. So if we think about the high yield universe on a global basis, there'll be many, many companies in our universe that don't report a huge amount of ESG data, whether that's carbon related or social criteria, governance data points. What we prefer to do is to focus our engagement specifically on where we feel it's most important for us to have an influence, or obviously where we feel it's important to get that data. So, as you point out, I think things like high carbon companies in high carbon industries that don't report that data, they're key companies that we should be engaging with to try and get a hold of some information on strategy and to ultimately undertake our risk analysis on those companies in a proper way. That's really as an example of where we're focusing our engagement activity. And that similar parallels across social, across governance, where we feel there's a bigger risk or a more important area to focus on, that's what we're trying to do. And there's best use of our analysts team's time, as opposed to just sending out generic data requests on every single data point that we'd like to have for ESG analysis across the whole market, which would be very time consuming but also somewhat less successful, I would imagine.

Greg Campion: Yeah. That makes a lot of sense. The third challenge, I guess we've already talked about to some degree and it probably permeates a lot of this and that's the idea of data limitations. Now I know that strides have been made with third party providers and they're getting more sophisticated I'm sure by the day in terms of what they're able to provide and how many companies they cover and all that sort of stuff. But, it would be great to hear from your perspective, being in the weeds on this day in and day out, how would you assess the current state of play with regards to data in this space? And maybe again, what are you and the team doing to tackle this challenge of data limitations?

Gareth Hall: Sure. To the challenges as you mentioned, and we just to give you a bit of color on where we are at the moment, so we have access to third party analysis sources. And we certainly incorporate those into our analysis in terms of looking at the points that are flagged and highlighted by those types of reports. I think within high yield in particular, it remains very critical to undertake our own commercial analysis. We still feel the access to companies from third parties is still somewhat limited or restricted. Whereas as a large analyst team, we have the ability to actually undertake commercial analysis on the companies we're looking at and speak to senior members of the organization. So that for us is very helpful despite the lower level of data availability. So I think in- house diligence is critical in this asset class. Another thing we're very positive on, and we think is hugely important is collaborative engagements across the high yield market. If you think about the things we've discussed already, as part of this discussion, you will have noticed that I think everyone in high yield will be suffering from a similar lack of data. And going forward, we're going to see a huge amount of demand from ourselves, from our investors, from income and regulation on a global basis around the provision of that data. And what we often hear from our companies that we invest in is, they want to start providing this data but they are somewhat unclear at this point on what they need to do or what data they need to provide. And they have limited bandwidth in some cases at management level to actually produce all this data. So what we've been doing to give you an example is where we're part of the European Leveraged Finance Association's, ESG committee. So what we're doing is basically as part of our initiative, interacting with the companies through round tables and the arranging banks, the financial sponsors to basically put in place frameworks and fact sheets around what we feel is the investment grade market we would like to see in terms of base levels of disclosure from the company's they invest in, in different sectors on key ESG topics. That's an example of something we've been heavily involved in and is really a great starting point to help companies in the high yield market to begin to disclose data where they haven't done historically. So I think those kinds of initiatives are critical alongside the in- house due diligence and production of ESG ratings and carbon and analytics. And those are the tools we have at our disposal as we touched on before.

Greg Campion: Yep. That makes a lot of sense. And I think that idea of doing the in- house due diligence, I mean, that's very consistent with Barings approach just generally speaking in terms of having very well- resourced teams to do the underlying credit analysis, and it's almost like this is an integrated piece of that. Now on the collaboration side, that's really interesting to hear and you think about asset management being a hyper competitive industry of course, but it feels almost like, and I don't want to be too Pollyanna- ish here, but it feels almost as if there's a partnership across the industry on ESG specifically. And you mentioned some of these initiatives that you and the team are involved with in terms of some of these industry collaborations, but is that your sense? I mean, do you feel like there's actually a real partnership across the industry in this space?

Gareth Hall: Yeah, no, I do generally think that's correct. I think ultimately it's in everyone's best interest in the market to have better data on the ESG topics because, ultimately that allows everyone to do their analysis and their own, take their own views on the risks associated with those sustainability points, so that benefits everyone from that perspective. And then also feeding into the wider views on climate change and various other topics. I think we'd all agree that it's important that everyone's working together to move the markets forward and ultimately the world forward on these topics because that's in everyone's interest as well. So certainly on my interaction on these types of committees, I think everyone is pulling in the same direction in terms of improving the market, in terms of data availability for ESG analysis.

Greg Campion: Yeah, that's great hear. Well, we've covered a lot of ground in a short amount of time here. I did want to ask you one final question and that is, given your seat, that's kind of in the center of all things ESG, high yield, I guess, even broader fixed income, et cetera. What do you think is next? So, we already talked about how the industry has made so many strides, even in just the last couple of years. It's almost difficult to keep up with to be honest, but where do you think we go from here? If you look out over the next couple of years, even the next decade, I know it's impossible to predict, but what do you think, what big things are coming down the pipe here for ESG?

Gareth Hall: Sure. And I think it's going to be hugely busy and there's going to be lots of market developments in a very short period. I mean, if you think about a few of the things we're thinking about this year and at the moment. So we have a number of incoming global regulations that we will have to deal with as Barings, as a global high yield team, around producing data for our clients and reporting, so that's a huge project area which we're working very hard on. And also in terms of market developments we're seeing a lot of very quick changes on the ESG front as well. So if we look at the leveraged loan market for example, now we're seeing a lot of what's known as sustainability margin ratchets. So basically that's where the margin on a loan moves up and down based on achievability of sustainability targets at companies, so that's a relatively new phenomenon that is actually in the majority of new issuance now in the leveraged loan market. That's a very interesting developments and we're obviously also involved in various committees across the market to feed into our views around how those, how that develops in terms of trends. And similarly were starting to see now in high yield, a lot more sustainability linked bond issuance or green bond issuance, so huge amounts of movement in terms of the market and what we're seeing. And I think the great thing is Barings across our teams is that everyone has been becoming a lot more engaged on these topics and looking at these risks for the companies we invest in. So, definitely coming more and more part of our culture in terms of how we invest.

Greg Campion: Absolutely. I mean, it's palpable, I can feel it every day. Well, it seems that there's going to be no shortage of topics to talk about in the space in the years ahead, so I'd like to continue the conversation. So hopefully we can have you back on Streaming Income in the near future. In the meantime for our listeners, I mentioned the piece that Gareth wrote, so I'll point that to you again, if you go to Barings. com under the viewpoint section and navigate to high yield, you'll find a piece called ESG: Three Challenges High Yield Managers are Tackling Today, which covers similar ground to what we covered in our conversation today. So Gareth, this has been great, very enlightening for me. I look forward to continuing to learn more on this subject and hopefully bringing some of those insights to our listeners as well. So, thanks for joining me today Gareth, it's been great.

Gareth Hall: Pleasure, and thank you very much for having me and speak soon.

Greg Campion: Thanks for listening to episode number nine of season four of Streaming Income. Remember to follow us on Apple Podcasts or Spotify so that you are the first to hear about our latest episodes. Thanks again for listening and see you next time.