For years, investors have traditionally treated financials as a distinct group within the credit markets. Financial institutions are critically important to a healthy and functional global financial system. During the 2008 financial crisis a number of prominent financial institutions collapsed, while others were on the precipice of failure if not for government intervention. In many cases, poor corporate governance was at the root of these problems. While we believe that a proper investment approach should integrate corporate governance considerations into the credit research process, we believe it is also important to take a broader ESG perspective in evaluating their credit profiles.

Environmental, Social, and Governance (ESG) considerations are nothing new for corporate bond fixed income investors, as assessing sources of downside risk is integral to the credit research process. Corporations that adopt sound corporate governance, strong environmental and social management practices can improve their credit risk profiles, leading to higher ratings, lower financing costs and stronger businesses. For fixed income investors, these factors can help reduce downside risk and portfolio volatility while increase the risk-adjusted return potential in a well-diversified portfolio.

In contrast, weak corporate governance factors and poor environmental and social management policies may each lead to higher cost of debt and, in the extreme, corporate default.

The Global Fixed Income Team’s ESG Approach

The Global Fixed Income Team’s approach to ESG investing in financial institutions is consistent with its general philosophical approach - eliminate uncompensated risk by cutting off the tails of the return distribution. ESG considerations are particularly pertinent to left tail management, as ESG risks can be exceptionally high without commensurate compensation.


Financial institutions are typically set apart as a distinct grouping within the credit markets, due to their regulated nature, higher leverage and indeed greater (albeit perceived) complexity. While some of these factors may mean financial institutions are analyzed through different research lenses than industrial companies (e.g. Common Equity Tier 1 ratio vs Debt to EBITDA as a measure of leverage), we believe there is more similarity between financial institutions and most industrial corporations when taking a research approach that integrates an ESG framework. However, the significance of each of the E, S and G factors likely differs across industries.

Governance

Financial institutions’ ESG scores have typically been backward-looking and heavily focused on the governance component.

We think the past’s heavy focus on G-factors was appropriate as banks’ governance practices were weak, both going into the great financial crisis and emerging from it. Since then, we have seen the US banking industry make considerate governance improvements, both through voluntary and regulatory actions, as US banks have had to comply with increased bank regulations, notably the Dodd-Frank Act.

US banks’ governance risks are now more easily recognized and capable of being compared against each other. For example, the Federal Reserve publishes the results of the annual stress tests for the larger banks, and published living wills detail how the larger banks envision their wind-down in the event of a failure. These studies provide investors with a window into banks’ governance and risk management processes.

It is also worth noting that regulators have taken note of bank managements’ failures as banks are now required to hold capital against intangible operational risk assets. The size of these assets actually increase when banks are fined and/or incur regulatory penalties.

We point out that as regulations are rolled back for some of the smaller banks, investors will need to keep a careful eye on governance and engage with management to ensure that the transparency around risks faced by banks is retained. As an insight into our Governance assessment we actively monitor how banks tackle the transition from LIBOR to SOFR (see Risk Consideration 1) as we view this as a test of strength around governance and risk management.


Social

Governance factors tend to be well understood. But, we now see the nature of ESG factors changing for financial institutions with S- and E- factors gaining more understanding and relevancy.

We expect that Social factors will become increasingly important when assessing risks within financial institutions. Perhaps the clearest evidence of this is JP Morgan’s Chairman and CEO Jamie Dimon’s statement in August 2019 where, as Chairman of the Business Roundtable, he noted:

“While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders.”1

1 Business Roundtable Statement on the Purpose of a Corporation, August 19, 2019

From Dimon’s public comment, we may discern that corporations are realizing their actions have a wider influence on the economy and society, and their purpose should be broader than one solely focused on shareholder value maximization. For example, this year, we saw the larger banks─JPMorgan and Wells Fargo─reduce their relationships with the private prison industry as part of their “environmental and social risk management process.”

When examining financial institutions we explore several social factors to assess risk. Included are labor management practices, diversity of workforces and human capital development. We also study product liability and the wider impact on corporate stakeholders. For example, in the case of Wells Fargo, which engaged in aggressive cross-selling practices that led to the opening of millions of fraudulent accounts on behalf of their clients without their consent, we considered the possibility that account holders’ credit scores may have been adversely impacted, or they experienced increased cost of borrowing or even denial of credit.

Looking forward, cyber security and financial product security/safety are likely to be important factors for risk assessment (see Risk Consideration 2).




Environmental

Similar to social factors, environmental factors are becoming increasingly important when assessing how financial institutions manage themselves and their position in the wider investment universe.

When analyzing environmental factors we examine banks’ lending practices and exposures to certain industries where there is a clear environmental impact such as the Canadian banks exposure to energy as a shift to a low-carbon economy is underway. While the financing of the energy market has largely been disintermediated with the debt capital markets stepping in as banks have stepped away, the larger size of the natural resource sector in Canada means Canadian banks are still exposed to the fluctuations in asset prices. Commodity prices─and the plant and equipment used to extract physical commodities─may at times not fully reflect carbon-related risk, which could raise the cost of transitioning to a low-carbon economy. For example, at 3Q 2019, Royal Bank of Canada had 4% of its commercial loan book tied to the oil and gas sector.

We also look at banks’ lending postures to industries where there is a larger human environmental impact. For insurance companies, particularly property and casualty insurers, we are attuned to the risks from climate change. Thus, we know these risks create heightened uncertainty for the sector due to the greater frequency and severity of natural catastrophes, and exposure to carbon transition risk through their investment portfolios and the possibility of stranded assets.

Finally, our investment process encapsulates the positive environmental impact financial institutions can create (see Risk Consideration 3).


How MacKay Shields’ Global Fixed Income Team Engages with Financial Institutional Issuers

While some perceive that bond investors have little ability to influence company management teams, we do not subscribe to this belief. Importantly, this view fails to recognize that corporate bond investors frequently operate in the primary funding markets much more than equity investors, for example. If companies are unable to secure corporate bond funding, the viability of corporations would likely be threatened.

At MacKay Shields, as managers of capital on behalf of our clients, we recognize that we have a fiduciary duty. To meet our responsibilities, the Global Fixed Income Team systematically engages with issuers and holds ongoing investor dialogues on ESG topics as part of the new issue process when meeting corporate management teams. It is during these meetings where we believe we can encourage issuers to more effectively internalize ESG processes for the benefit of management and investor. The end objective is to deliver stronger risk-adjusted returns for our clients.

The examples of risk considerations presented herein are presented for informational purposes only. Nothing contained in this publication shall be construed as a representation or warranty, express or implied, regarding the advisability to invest in or include companies in investable universes and/or portfolios. Companies or securities identified herein do not necessarily represent past or current holdings of MacKay Shields funds or strategies. The examples herein are intended to illustrate the portfolio management team's investment discipline only. The examples not intended nor should it be construed to be a recommendation to buy and sell any individual security. The examples should not be considered predictive of future transactions or commitments made by MacKay Shields LLC nor as an indication of current or future profitability.