Applying ESG considerations to equity and standard fixed income offerings becomes a little bit easier with each passing day. In the world of securitized credit, however, it’s still a very new concept. However, as II discovered in its conversation with Jose Pluto, Senior Structured Research Analyst and Portfolio Manager, Sustainable Fixed Income Strategy, Aegon Asset Management US, there can be tremendous value in doing so. Pluto has been instrumental in formalizing Aegon AM US’ ESG integration approach for structured securities and was a key architect of developing the proprietary sustainability assessment process for structured securities. In this conversation, Pluto shares his perspective on a corner of ESG integration that is, for the most part, new territory for investors.
In your experience, do investors tend to think of securitized credit in the context of ESG?
Jose Pluto: Generally not. Formally incorporating ESG considerations is comparatively nascent in the securitized space. Unlike equities or corporate bonds, where there are more standardized metrics such as the Sustainable Accounting Standards Board’s Materiality Map and independent research providers such as MSCI and Sustainalytics, ESG is a much newer, less evolved topic in the securitized world.
What are the potential benefits for investors?
Pluto: ESG analysis provides a systematic way to incorporate what we believe are investment best practices. Simply put, we see it as good old-fashioned credit work. Systematically integrating ESG factors can help uncover risks and opportunities that could impact collateral, structure and/or issuer performance and ultimately, portfolio performance. To give you some context, at Aegon AM US our structured finance research process is built around answering two basic questions: Can this business or issuer create value for its stakeholders? And is the value that’s created appropriately distributed amongst the business, the customer and bondholders? We believe ESG considerations are integral to answering those questions.
Data is a focus of almost any ESG investment discussion. Is quality data regarding securitized loans more or less difficult to access?
Pluto: It’s not necessarily harder or easier, it’s just different. There aren’t industry standards around ESG-related data for securitized credit. Assessing ESG factors for securitized assets requires a more creative approach relative to corporate bonds given the lack of third-party ESG metrics and research. In traditional credit markets, for example, a large portion of the issuers are public companies that have ongoing quarterly public filing requirements. Many issuers have active ESG engagement efforts and have reporting that can be mapped to established ESG frameworks. And a pretty good portion of that universe is also covered by third-party dedicated ESG research providers.
In contrast, securitized issuers tend to be private companies, so for the most part third-party ESG research is not available. With securitized, you’re generally looking at a dedicated collateral pool that’s been transferred into a securitization vehicle. An abundance of information about that securitized vehicle is released at issuance in the offering documents, including very detailed information about collateral composition, structural features and the roles and responsibilities of transaction participants – in a way, you’re much closer to the assets. Particularly in consumer-related ABS, CMBS and RMBS, this data can be very granular with information available right down to individual obligors and loans, with different data fields from which you can glean insights about the type and nature of the origination, the collateral’s consistency with the sponsor’s stated value proposition as well as identify potential ESG-related opportunities and risks.
You mentioned the environmental aspect of applying ESG to securitized is quite nuanced. How so?
Pluto: Many approaches, such as UN PRI, frame the environmental part of ESG in the context of how a business is exposed to climate change and what it is doing to adapt. For securitized, this is a useful starting point, but there are more nuanced environmental-related considerations that can impact investment outcomes and vary by collateral type, structure and issuer. We seek to answer two main questions: are there potential environmental concerns, or opportunities, around the sponsor’s business model that could impact performance? And ultimately, are there mitigants in place to help address these risks? For example, the collateral, borrower or business in a securitization may be exposed to rising insurance coverage costs from increased frequency of stronger storms. In certain situations, the collateral or structure could also have exposure to natural disaster risk such as hurricanes, earthquakes, wildfires and volcanoes that may not be insured. Additionally, some business models such as railcar leasing may have man-made environmental risk that can impact collateral performance.
Agency credit risk transfer (CRT) deals are one example of a securitization structure that can allow natural disaster exposure to manifest itself in credit performance in a way that bondholders may not fully appreciate. Government sponsored entities (GSEs) often engage in CRT transactions to sell portions of the credit risk in their mortgage guarantee portfolio to private investors. However, Agency CRT transactions don’t scope out natural disaster-related defaults from other types of defaults – they’re treated as a traditional credit default. Natural disasters such as hurricanes are typically accompanied by an uptick in delinquencies and defaults by borrowers, and you can imagine why – homes are destroyed and storm victims might not have adequate insurance coverage, or they might have had wind coverage, but not flood insurance. In 2017, when Hurricane Harvey hit Houston, the fifth-largest metro area in the U.S., according to Bank of America research, for most of the outstanding CRT deals, anywhere from 2% to 4% of the of the loans included were exposed to mortgages on homes located in the five metro areas in Texas that were most impacted by the storm. With Harvey, the uptick in delinquencies led to near-term price dislocation in certain subordinate CRT bonds as investors realized the risk and repriced these transactions to reflect the increased potential for losses.
And what are some nuances around social factors?
On the flip side, environmental considerations can lead to attractive investment opportunities. Solar panels and generating electricity using photovoltaic cells is one of the cleanest, most renewable sources of electricity at the moment. Growth in the renewable energy sector has given rise to a new form of securitized investment opportunity – solar ABS. From an environmental perspective, solar ABS, which are securities collateralized by consumer receivables originated by solar energy companies, provides potentially attractive opportunities for consumers and investors looking to support the renewable energy movement.
Learn more about opportunities in solar ABS.
Pluto: Social considerations for securitized assets span a broad spectrum of areas including regulation, product design, origination and servicing standards and customer satisfaction that can impact the collateral, the structure and the issuer. The primary areas of focus are on the origination and servicing practices, product design, the transaction’s structure and incentives as well as evaluating the business along dimensions such as customer satisfaction and regulatory compliance. First and foremost, we seek to establish whether the business provides the borrower with a product that provides utility and value. We look to assess incentive structures, evaluate where these could create a systematic adverse relationship between the business and its customers and determine what mitigants are in place to manage these risks. And we review the business and management team to establish what prior controversies or specific regulatory concerns might exist that could be detrimental to credit performance.
Consider for example student loan refinancing ABS. Historically student lending in the U.S. was concentrated among a few lenders providing limited, very expensive options. More recently, new finance companies have emerged that allow borrowers who have become established in their careers and demonstrated consistent creditworthiness to reduce their debt burdens by refinancing at lower rates that better reflect their improved post-graduation credit profile. This product design lowers the ultimate cost of education ex-post, helps minimize exposure to the much-publicized problems with student loan debt and provides investors with a potentially attractive structured credit investment opportunity.
How do you assess governance factors?
Pluto: Governance factors are a critical component to assessing the credit profile of a securitized deal. Offering documents govern the transaction’s economics and determine transaction participants’ roles, rights and responsibilities. Among other things, these documents spell out how cash flows are divided among investors, structural credit protections, collateral inclusion criteria, borrower servicing standards, reporting and disclosure requirements as well as investor protections such as representations and warranties - backstops where the issuer attests to the collateral being originated in conformance with applicable underwriting standards, laws and regulations. We look for a deals with a strong alignment of interest between the collateral performance and the sponsor’s economics, as well as seek to understand transaction processes and procedures. We also evaluate non-structural aspects that could impact the transaction such as the issuer’s ownership structure (are they publicly traded or privately held?), management’s business acumen and issuer’s communications and disclosure track record.
There must be some unique characteristics related to ESG regarding the various types of securitized loans such ABS, CMBS, RMBS, yes?
Pluto: The securitized world can be segmented into two broad buckets – consumer-oriented, such as auto loans, solar, student loans and residential mortgages; and commercially-oriented, such as commercial mortgage-backed securities, and ABS on assets like transportation equipment and cell towers.
On the consumer side, social and governance factors are generally the most relevant. From a regulatory perspective, customer-facing businesses will generally face a bigger burden to show that they acted fairly, and in the customer’s best interests. We look for aspects of the business’ operations and practices that create a systematic adverse relationship with the borrower. That includes evaluating everything from the origination model and how the value proposition is disclosed to the borrower, to servicing - the backend customer service and collections activity, to late stage default management, foreclosure and repossession practices.
And what about on the commercial-facing side?
Pluto: For starters, commercial-oriented securitized loans tend to involve more sophisticated borrowers, but ESG-related considerations are still very relevant. Environmental concerns are very relevant – as mentioned earlier adverse environmental exposures can increase operating costs. Additionally, trends such as energy efficiency could lead to positive business outcomes for businesses such as data center operators and cloud computing equipment makers – several of which have used securitization financing. Governance factors are again a major consideration. It is especially important to focus on the alignment of interests between different parties to a transaction. The evaluation should cover the originator - the entity producing the collateral that is going into the deal, the servicer who is responsible for collecting payments and managing the transaction and the sponsor - the party who ultimately holds the junior-most equity risk in the deal. For example, if the captive finance operation of a major industrial company originates and securitizes loans for financing their customers’ purchases, they will typically hold the most subordinate credit risk in the transaction. But in other structures such as aircraft ABS, you may have an entity originating lease receivables and selling them to a private equity fund, for example, who in turn uses securitization to get leverage on that pool of assets. Despite selling the lease receivables, the aircraft lease originator, may be kept on as the transaction servicer; an entity that is first in line to be paid from any deal cash flows and has little-to-no credit exposure. The result is that there are multiple entities with unclear motivations and asymmetric access to information about transaction economics, holding different parts of the transaction, being paid with different priorities in the waterfall. As such it’s important to understand what the set of incentives for each of those entities might be and how potential conflicts might be mitigated.
What qualities are important when searching for a strong partner for ESG-based securitized credit investing?
Pluto: We believe assessing ESG factors in securitized bonds requires a research-intensive approach to dissect the plethora of available information and distill it into actionable investment recommendations. A long track record of fundamental credit work – detailed reviews of collateral pools, transaction structures, and issuers – is evidence of the experience required to more fully understand the potential ESG and non-ESG risks within securitized credit. Furthermore, a manager with experience that goes beyond the traditional well-trafficked benchmark sectors and has participated in new sectors across the credit spectrum through multiple business and market cycles, may be better positioned to identify and analyze ESG-related risks.
Looking for insights on nearly every aspect of ESG? Here they are.
Disclosure
Past performance is not indicative of future results. The information contained in this article is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, sector, strategy or investment product. The article contains the current opinions of the firm and is accurate as of the date of the article. Such opinions are subject to change without notice. The firm is under no obligation, expressed or implied, to update the material contained herein.
All investments contain risk and may lose value. Socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised by any company of Aegon Asset Management will reflect the beliefs or values of any one particular investor. There is no guarantee that socially responsible investing (SRI) products or strategies will produce returns similar to traditional investments.
Specific sectors mentioned do not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable.
Structured Finance assets (such as ABS, RMBS, CMBS and CLOs) are complex instruments and may not be suitable for all investors. The assets may be exposed to risks such as interest rate, credit, liquidity, issuer, servicer, underlying collateral, prepayment, extension and default risk. Investors typically receive both interest and principal payments for a security and these prepayments may reduce the interest received and shorten the life of the security. Although some types of structured finance securities may be generally supported by a form of government or private guarantee, there is no assurance that guarantors will meet their obligations.
This article contains forward-looking statements which are based on the firm's beliefs, as well as on a number of assumptions concerning future events, based on information currently available, and are subject to change without notice. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein.
Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.
