High Yield - Q&A

The High Yield team joined First State Investments in 2016. This question and answer was conducted with the head of the team, Matt Philo in New York. In it, Matt discusses the team’s investment philosophy and approach, how ESG factors are considered when investing, and how they see responsible investment and stewardship practices evolving in the United States. 


 

Introduction

The High Yield team joined First State Investments in 2016, Matt Philo is the head of the team and is joined by Senior Co-Portfolio Managers Michael Elkins and Jason Epstein. Together, the three comprise a highly experienced team drawing on many years of investment management experience, working with uniquely qualified credit analysts. Portfolio management responsibilities are shared across the three managers, with all investment team members participating in credit discussions relevant to their industry coverage.

The other team members include a dedicated specialist high yield trader/dealer Linda Grillo, Senior Analyst David Licht, Analyst Ryan Spitz. Further analyst resources are being added to the team in the remainder of 2017. Several team members have worked together for over 10 years and have known each other for more than two decades.

The team’s structure ensures that key-person risk is minimised; investment decisions are taken collectively and in consultation with all team members.

"The High Yield team is made up of seasoned credit investors with investment experience, averaging 22 years and spanning a variety of market environments."

The team has expertise in managing and designing high yield portfolio strategies with a unique blend of qualitative and quantitative skills. Long-standing relationships in the market are leveraged for idea sourcing, market intelligence and to facilitate trading.

Please tell us about the investment process and philosophy

 

The investment philosophy is rooted in the conviction that high yield corporate fixed income investing is first and foremost about risk control. Default risk is the dominant risk factor, and all portfolio investments must meet stringent, and quantifiable minimum 'margin-of-safety' requirements.

Secondly, the investment philosophy strives to never buy credit risk at the wrong price, utilising a default-adjusted, yield and spread methodology. This approach involves maximising the default adjusted yield and spread of a diversified portfolio.

We believe the optimal, risk-adjusted investment process combines both dynamic fundamental, bottom-up credit selection, with continuous top-down portfolio risk management systems.

Finally, we view team culture as integral to the successful implementation of the investment process. We believe in a collaborative team approach in as non-bureaucratic, transparent and collegial team environment as possible. The result is a highly interactive open office culture that grants all team members significant earned autonomy and a direct sense of ownership and alignment with our clients’ interests through profit-sharing participation.

While our investment process is rigorous in implementation, it is conceptually simple to summarise:

  • Minimum Yield Screen, with 'positive event potential' exceptions.
  • Minimum-Margin-of Safety requirements; quantified and stringently applied.
  • Qualitative Fundamental Corporate Assessments to further safeguard against default risk.
  • Default Adjusted Methodology focused on the spread premium necessary to overcompensate for default risk.
  • Catalysts for Total Return expected to result in total returns above and beyond a coupon based yield.

The High Yield team’s distinguishing features and competitive advantages are listed below:

ESG factors have long been used in equity and direct investments to add value, with strong evidence to that effect. Why do you think it has been more difficult for fixed income investors?

We don’t view ESG factors as being more difficult to implement for fixed income investing. Indeed, many ESG components are fully captured in our fundamental credit analysis and investment process. While it may appear that fixed income investors have been slower to adopt ESG investment processes, it’s more accurate to characterise it as being less visible, because it is typically expressed through a non-public and less active approach given the creditor position.

Fixed income investors are more likely to abstain from making an unsuitable fixed income investment in a company that has an excessively high ESG risk profile. However, public and private equity investors are much better equipped to leverage their position as owners to effect change on a board of directors and executive management team to implement changes to a company's business practices.

Key factors such as corporate governance, business practices, industry and contingent liabilities related to environmental issues are researched thoroughly and heavily influence investment decisions. Third party specialists that have developed specialised ESG rating methodologies are also used to supplement core credit analysis. ESG risk receives further diligence through direct interaction with management, SEC filings and financial statement and footnote analysis.

"Fixed income investors are more likely to abstain from making an unsuitable fixed income investment in a company that has an excessively high ESG risk profile."

How have you overcome some of these challenges when establishing your investment process?

We have taken an active approach when trying to identify and assess the importance and materiality of each ESG issue. When investing in an individual company or security, we analyse certain factors such as community relations, employee relations, corporate governance, environmental issues and any contingent liabilities. Other relevant topics, such as executive compensation, employment conditions, and any other controversial impact the business may have on the environmental ecosystem, including pollution, are risk assessed and considered heavily in whether an investment is deemed appropriate or not and in the relative and absolute price of the security.

We have determined that screening out issuers that have undesirable business models or which do not generate a positive impact is insufficient. Investing in companies that are focused on improving their sustainability has the potential to protect and enhance our investment returns. Most issuers can benefit via continuous improvement along a wide range of areas such as energy efficiency, workplace inequality and devising conscious environmental policies. 

ESG risk assessment can be enhanced through engaging with management, specialty ESG rating services such as RepRisk and Sustainalytics, other fixed income investors and additional due diligence with industry consultants. This entails a forward-looking approach with the goal such that the benefits and increased value will accrue to investors.

"We have determined that screening out issuers that have undesirable business models or which do not generate a positive impact is insufficient. Investing in companies that are focused on improving their sustainability has the potential to protect and enhance our investment returns."

 

 

You have a global database, ION, which allows teams across our fixed income suite to share information and ideas. How important is this system in fully integrating ESG factors into your investment process?

The ION global database allows us to effectively analyse and report ESG ratings across many different securities, industries and corporate issuers. In addition, it allows us to effectively manage ESG factors across multiple portfolios. ION helps us determine how ESG influences returns and improve performance over the long term. ION can also assist us in implementing processes to deal with controversial investments where there may have been differing views.

As part of our investment process, we have integrated a third party provider that specialises in ESG risk analytics and metrics into the ION database. The external research and proprietary ESG risk database provides ESG ratings that allow us to evaluate issuers relative to their industry peers. All of this information is centralised in the ION database and is shared across our fixed income teams globally.

Finally, ION allows us to share ESG-relevant issuer news on a timely basis. For instance, The Hertz Corporation launched a new carbon offset program that provides corporate customers worldwide with the opportunity to reduce the carbon footprints associated with their vehicle rentals through the purchase of carbon offsets. Carbon offsets support emission reduction projects, which benefit the environment. This information can be shared on our database and will be available to all our teams.

"The external research and proprietary ESG risk database provides ESG ratings that allow us to evaluate issuers relative to their industry peers."

Over the last couple of years, there seems to have been a real shift with large US managers and pension funds adopting reasonable investment practices. How do you see this developing from here?

One of the biggest evolutions in the modern investment market is that institutional investors have become the key owners of stock as opposed to individual investors. Insurance companies, mutual funds and pension funds with long-term pay-out obligations are increasingly much more interested in the long-term sustainability of their investments than the individual investor looking for short-term gain. We believe that the management of public companies will also become more transparent on disclosing ESG risks as US investors increase their focus. 

Do to the growth in large US investment managers and pension funds adopting responsible investment practices, many institutions have now established departments and divisions exclusively addressing responsible investment. In addition, we believe that boutique firms and software will continue to be created that specialise in advising and consulting on environmental, social and governance-related investments.

As investors continue to adopt ESG considerations into investment analysis, it will become more important for this information to be externally verified and for certain universal standards and regulations to be established. Despite ESG data often being qualitative in nature, we think the ability to quantify some aspects will also lead to higher adoption and continued growth.

"As investors continue to adopt ESG considerations into investment analysis, it will become more important for this information be externally verified and for certain universal standards and regulations to be established."