In two recent blogs, we discussed ESG implementation and whether is it possible to construct a dedicated high yield ESG portfolio that meets the ESG objectives of its investors. From DDJ’s perspective, we absolutely believe that ESG-focused high yield investors can drive change that is consistent with their ESG objectives, primarily through capital allocation decisions that affect the cost of capital for issuers across the high yield market.
- ESG in High Yield: Shortcuts Versus Thoughtful Integration
- ESG in High Yield: Shortcuts Versus Thoughtful Integration, Part 2
Fundamentally, as investment managers, DDJ’s job is to allocate capital by determining which companies are more deserving of it than others. The word “deserving”, in a traditional investing context, means identifying which investment opportunities offer better financial metrics and, accordingly, an attractive risk-reward profile.
But what if we added non-financial considerations and allocated capital, for example, to companies that served as better stewards of the environment? Based on our experience in managing high yield investment strategies, the answer again is “yes”; this is possible, and in practice, this concept is nothing new.
For instance, gun manufacturers, tobacco companies, and adult entertainment companies, which have been subject to heightened ESG scrutiny for many years, must pay higher coupons when they raise financing through the high yield market.The cost of capital for any debt issuer is imminently demonstrable by the coupon that the issuer is required to pay when it raises debt capital. And while equity investors can certainly influence a company’s cost of capital, we believe that debt investors can also play an important role, particularly on an ongoing basis. Companies with debt in their capital structure need to periodically come to the debt market, simply because bonds and loans have a defined maturity date and accordingly need to be refinanced. As a result, high yield investors effectively determine a new cost of capital for such companies each time they issue debt.
The charts below show the example of the Coal industry in the high yield market. Since the turn of the century, the industry has transitioned from paying a lower cost of capital (defined by lower spreads over treasury rates) to paying substantial premiums, as compared to the market average. The price for capital went up, and the availability of capital shrunk, which contributed to a dramatic decline in the size of the Coal industry in the high yield market since mid-2015.
Today, in light of the increasing focus on climate change and the consequences associated with fossil fuel usage, funding the development of a new coal mine with high yield bonds is simply not in the cards. Of course, we fully realize that there have been other factors that brought us to this point, including heightened government regulation and competition from natural gas. However, it has also been our observation that, over time, there have simply been fewer potential buyers for coal bonds. Increasingly in DDJ’s experience, institutional clients of high yield managers have begun to include coal companies on their ESG-oriented exclusion lists. DDJ believes that investment managers with an institutional client base that did not altogether restrict investing in coal companies nonetheless had less of an appetite to buy coal bonds given the decreased liquidity of these bonds that has resulted from a declining potential buyer universe (due, in part, to such ESG-related exclusions). And so this dynamic fed on itself. In our view, it is safe to say that the lower availability of capital in the high yield market accelerated the decline of the Coal industry in North America.
coal excess spread (bps)
coal: SHARE OF BROAD HIGH YIELD MARKET
Conversely, we have observed that companies that have a positive ESG impact (whether perceived by investors or in reality) enjoy a lower cost of high yield capital than their peers. For example, based on our analysis of the US Electric Utility high yield universe, high yield bonds issued by fossil-fuel powered utilities had approximately 60% higher spreads compared to their peers in the renewable energy sector.1 We believe that it is no accident that high yield issuance by renewable power electric utilities has increased markedly since 2014, as such issuers have been able to use this lower cost of capital as a competitive advantage to accelerate the growth of their businesses. As the positive ESG impact of a lower cost of capital for environmentally friendly electric utility companies is driven by market forces within the high yield market, such a phenomenon should not be overlooked by investors, as we would expect over time to see similar trends in other industries as well.
Interested in taking a deeper dive on ESG in the high yield space? The above post is an excerpt from our 2021 white paper, Dedicated ESG High Yield Strategies: Can They Achieve Their Objectives?
We invite you to download your free copy of the white paper, available below.