Bonds are not equities – Volkswagen
Our investment in the global car manufacturer Volkswagen provides a good example of how we incorporate ESG risks into our analysis. It also highlights how risks differ between bond and equity holders.
29 Jan 2021
January 20, 2021| Henley Fixed Interest Team
Environmental, social and governance (ESG) concerns are an increasingly important consideration for many clients. At Invesco, we have long recognised the significance of assessing ESG related factors as determinants of financial performance.
Successful investment is ultimately determined by the balance of two factors, risk and reward. Does the potential return you might receive from an investment adequately reflect the risks of holding it?
Our approach to assessing ESG risks is the same as for any other risk. That is, does it impact the issuers ability to meet its financial obligations, is the risk likely to increase or decrease, and is it reflected in the price.
So that we can capture these risks we have fully integrated ESG research into our investment process.
ESG risks are systematically assessed on a single platform, ESGIntel, which is accessible by the fund management team. This proprietary developed ESG quantitative risk tool, ESGIntel provides an ESG rating for each company along with details of how the company compares to peers within its industry and how ESG risks are evolving.
The systematic analysis of each issuer that this research provides is helpful in building our understanding of an issuer. However, it is only one of many inputs we use to assess a company’s risk. Ultimately, successful investment relies on in-depth, dedicated credit analysis to provide a comprehensive understanding of the issuer, its risks and the potential opportunities.
To this end, ESG is embedded in our credit analysis. ESG risks are considered by our credit analysts for materiality, direction and whether or not they are currently reflected in the spread of a bond.
Where possible and relevant we engage directly with the management of companies on ESG concerns that we think impact its creditworthiness. Alongside this direct engagement, we also engage with Invesco’s global ESG team.
Finally, we have also implemented an ESG portfolio review process for our funds. The reviews, which are undertaken by the global ESG team cover a wide range of ESG metrics on both an absolute and where relevant relative to benchmarks.
Download now the guide for the Henley Investment centre’s approach to ESG analysis and ongoing corporate engagement.
The following examples highlight our approach.
Bonds are not equities – Volkswagen
Our investment in the global car manufacturer Volkswagen provides a good example of how we incorporate ESG risks into our analysis. It also highlights how risks differ between bond and equity holders.
External ESG data providers typically score Volkswagen poorly. Their concerns are typically centred around the potential fallout from the company’s earlier diesel emissions scandal, as well as the ongoing decline in diesel car sales.
We agree that Volkswagen, like all automotive manufacturers, is highly exposed to the electrification of the industry and to changing regulations. However, these factors primarily impact on the company’s profitability, they have minimal impact on its balance sheet.
For us as bond holders, we want to know that Volkswagen will be able to continue to meet its financial obligations. Our focus is therefore on the balance sheet and cash flow.
Volkswagen’s financial position is relatively sound. It is one of the world’s largest auto manufacturers and has a solid BBB investment grade credit rating. The company has €25bn of liquidity, good access to capital markets, and a large market capitalisation that offers a great deal of comfort to creditors. Furthermore, the company has a positive net cash position and has continued to generate free cash flow even in a very difficult year such as 2020.
That being said, the Dieselgate scandal highlighted the importance of ESG analysis to both equity and credit holders. In the aftermath of the US Environmental Protection Agency notifying Volkswagen of its breach of the clean air act in September 2015, Volkswagen’s bonds saw a steep fall in price However, the company’s strong financial position meant that it continued to make coupon payments and the bonds have since recovered strongly.
We engage with Volkswagen on ESG issues primarily through our dedicated ESG team who work closely with the fixed interest team. The last meeting with Volkswagen centred on governance, emissions regulations and ESG risks relating to cobalt supply chains.
Combining these inputs with our own credit research leads us to believe that the Dieselgate scandal forced Volkswagen to get ahead of other mass-market manufacturers with vehicle electrification.
In our view, the scandal also forced Volkswagen to cut costs, which has improved profitability as a result. Covid-19 and difficulties with Volkswagen’s first electric car based on a bespoke electric car platform, the ID.3 EV mean that Volkswagen may fall foul of the new regulations although the company says it is “within a gramme or so” of the new rules. We don’t think the fines would materially affect the credit risk profile.
On the basis of this analysis, we believe that the yields available on Volkswagen bonds sufficiently compensates us for the risk (including ESG related risks) of holding the bond.
Sins of the Father – Wessex Water
ESG rating providers typically produce their analysis on the ultimate parent company rather than the issuing entity. As credit investors, while we will want to understand the legal structure of a company and any implications that may have to the creditworthiness, we think it important to distinguish between the ESG risks of each.
Wessex Water is a good example of how understanding where the ESG risk applies can create opportunities. The British utility has a low ESG rating, however, this is primarily a result of its parent company. Wessex Water is largely owned by a private Malaysian infrastructure investor, YTL Power International.
YTL scores poorly on ESG metrics because of the Carbon Dioxide intensity of its power generation businesses, poor ESG disclosures and weak corporate governance. As bond holders it is important to understand this distinction. Even though YTL is the owner, we are lending money to Wessex Water, a separate legal entity, which is a highly regulated, monopoly UK water company.
The regulator, OFWAT has a large amount of control over the company including the amount of return a company can make to shareholders and the payment of dividends. The regulator also sets “outcome based regulations” which reward or penalise a water company based on whether or not it meets specific targets set by the regulator.
These regulations often include ESG consideration such as combatting pollution, maintaining of supply and flooding. Given this legal set up and the importance of the regulator, we believe that we are well insulated from the parent company and so are happy to hold Wessex Waters bonds.
ESG risks are financial risks – Metro Bank
UK retail bank, Metro Bank is a good example of how understanding ESG risks can bring real investment benefits. As with all analysis, it is important not to rely on external providers but to undertake one’s own research.
Our own analysis of Metro Bank led us to have significant concerns about the company, which centred around its governance. Although the ESG rating agencies had their own concerns about Metro Bank, there was less focus on what we felt were the main problems with the company.
In our view, the key ESG issues centred on the influence of the founder and Chairman of Metro Bank, Vernon Hill, on the board of directors and corporate strategy as well as concern over conflicts of interest.
Hill founded what became Commerce Bancorp in the US. He resigned as Chairman and CEO of Commerce Bancorp due to questionable conflicts of interest which involved the bank’s awarding contracts for architectural services to Hill’s wife’s architect’s practice, InterArch.
Despite the concern this raised in the US, Metro Bank awarded similar services to InterArch. In its 2018 annual report, Metro Bank’s audit committee said that contacts were at “arm’s length” and were “at least as beneficial as those which could be obtained in the market from an alternative supplier”.
The weak response of Metro Bank’s board to this conflict of interest was a negative signal for us. We met with management to assess the boards strength but remained concerned. Given these risks we avoided investment in the bonds.
Our caution was proven correct in 2019. Metro Bank was found to not be properly accounting for its risk weighted assets (RWA), a critical calculation in the ability to accurately assess the risk of a bank. The RWA was increased by £900m increasing pressure on the bank’s capital buffer and so required more capital to be raised.
Further underlining our governance concerns was that the mistake was identified by the Prudential Regulatory Authority (PRA) rather than Metro Bank’s own management. Hill was eventually forced to also step down as Chairman from the Metro Bank board.
Using our influence - Aviva
One of the strengths and responsibilities we have as investors at Invesco, is the ability to engage with the management of a company we are lending money to. At times this engagement can have a significant influence on fund returns.
In instances when the ESG risk is material we engage directly with company management. Other business as usual ESG engagements are conducted by Invesco’s ESG research team, which uses Invesco’s ownership of both bonds and equity to increase our voice as a stakeholder.
The ESG research team conducts its own ESG research in preparation for meetings and discusses with the relevant stakeholders across Invesco to ensure that companies are questioned on the relevant ESG topics. An Engagement Report for these meetings is shared across investment teams.
In 2019, Aviva announced plans to call (redeem) their irredeemable preference shares at par. This was an extraordinary decision for Aviva to make. The shares were sold and detailed in the issuing prospectus as “cumulative irredeemable preference shares” and they were widely purchased as such.
The relatively high level of income paid by the preference shares meant that they were in high demand and an important source of income. Indeed, we held them in many of our income funds. This strong demand meant that prior to the announcement the preference shares were trading at around 175% of par.
If Aviva were to redeem the shares at par, it would not only remove an attractive source of income but would also lead to potentially significant capital losses for holders. Given the potential that Aviva’s actions could set a precedent, the announcement led to significant uncertainty across the preference share market.
As shareholders we were an integral part of the bondholder group that pressured Aviva to reconsider its decision. Aviva subsequently announced that it would no longer be redeeming the shares. We continue to hold the high yielding preference shares in our portfolios.
As these examples illustrate, ESG factors can, and do, have a material impact on bond returns. The analysis of these factors is therefore not a nice-to-have marketing strategy, but an important and integral part of understanding the risks, and therefore potential returns of a bond.
At Invesco, credit research and risk assessment, including ESG related risk, is a core strength of our investment approach and an important factor in the success of our funds. As ESG awareness and considerations become increasingly important, our focus on research should mean we can continue to accurately assess the balance of risk and return of bonds.
INVESTMENT RISKS
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IMPORTANT INFORMATION
All data is as at 30.11.2020 and sourced from Invesco unless otherwise stated.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.