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RISCURA: Expert Opinions: Edition: September / November 2020

PENSION FUND REFORM IS CRUCIAL IN AN ENVIRONMENT OF PERSISTENTLY LOW INTEREST RATES

Fran Troskie, Investment Research Analyst, RisCura

 

A Group of 30 report, published late last year, estimates that the world’s top economies will face a pensions shortfall of just over $5 trillion by 2028 and $15.8 trillion by 2050. It is anticipated that this shortfall will be even greater given the impact of the COVID-19 pandemic once this report is updated. The likelihood is that the pandemic has brought the crunch-point forward for many retirees.

The reason is threefold. Global stock markets, and pension fund investments, have been hard-hit by the protracted lockdown measures implemented in most countries to stem the tide of infections. Even though stock markets rebounded in the second quarter of 2020, major markets are still noticeably lower for the year-to-date. European markets still have a long way to go to recover, with a 12.9% year-todate loss in the STOXX All Europe. US markets, arguably some of the quickest to recover, are still down 3% (S&P500). Emerging markets are 9.7% in lower in dollar terms. The notable outlier, Chinese markets, have recovered well, and the MSCI China A Onshore and MSCI China are 4.6% and 3.5% higher, respectively. In South Africa, the SWIX has registered a 6.3% loss for the year-to-date. Of even greater concern is that these assets, which are traditionally stalwarts for pension funds, such as property and bonds, have been slower to recover. The FTSE/EPRA NAREIT Developed Rental Index, a gauge of global property returns, is down 20% and the South African equivalent, the All Property Index (ALPI) has lost over 38%.

The second reason is that, during lockdown, many employees were unable to work and were classified as temporarily absent from work or, in many sectors, now face retrenchment. South Africa hit a new record unemployment rate of above 30% and this does not yet factor in job losses during the second quarter. This has resulted in a few different scenarios.

The first scenario is that some retrenched workers in South Africa were forced to take early pension pay-outs to fund their day-to-day living expenses. Early pension pay-outs come with heavy taximplications and substantially reduce the savings pot. The second scenario is that companies were allowed by the Financial Services Conduct Authority (FSCA) to temporarily reduce or suspend employer contributions where workers were still earning salaries. For the lockdown period, there is little to no money coming into members’ pension pots. The third scenario sees workers, who were put on unpaid leave during lockdown, receive no contributions to their retirement savings during this period. In all three scenarios, members’ pension pots are far smaller than they would have been, and likely far smaller than would allow for a comfortable retirement.

The third reason is that interest rates, which were already extremely low, were cut even further in most countries to help economies navigate the pandemic. The current environment of record low interest rates (intended to kickstart flagging growth during the COVID-19 pandemic) has put untenable pressure on pension funds. Bond yields in Germany and Japan, for instance, were in negative territory for some time. Where pension funds rely largely on bond yields to fund members’ retirement income, such low or negative rates has led to talk of reduced pension pay-outs to retirees, or increased premiums for working individuals.

The South African Reserve Bank, like other central banks, has already lowered interest rates in 2020, and analysts are predicting a further 25 basis point rate cut before year-end. South Africa may face a lowinflation, low-interest rate, low-growth situation, where real interest rates dip into negative territory. When inflation outstrips the interest rate, the real earnings on cash, deposits and shorter-dated fixed income instruments are eroded. Negative real interest rates mean that savers are effectively paying banks to hold their money. For retirees living off their savings this is a particularly hard knock. From a pension fund investment perspective, there are two key takeaways:

Member education and preservation of capital are essential: Trustees need to ensure that members are educated about the options they have if they are retrenched or absent from work. Ideally, members should be encouraged to leave their pension pots untouched, as the probability of recouping some of the losses incurred in 2020 gets higher the longer members stay invested.

Financial advisors and the retirement industry will increasingly need to turn to alternative, innovative asset classes and instruments to provide the stable, inflation-beating returns that bonds and listed property were traditionally thought to provide.

If the world’s retirement funding landscape does not evolve to meet the changing needs resulting from persistently low interest rates, the impact of COVID-19 and an aging population, the shortfall may hit even harder and sooner.

www.riscura.com

ASHBURTON INVESTMENTS: Expert Opinions: Edition: September / November 2020

Green bonds to achieve green shoots?

Santhuri Thaver, senior credit analyst at Ashburton Investments, explains a financing mechanism dedicated to funding climate-positive investments. It is gaining traction in SA, creating an opportunity to achieve required returns and a positive tangible impact.

 

What is a green bond?

It is a fixed income instrument issued on a listed or unlisted basis, the proceeds of which are earmarked to address climate challenges. Proceeds are not available for general corporate purposes, an issuance by a corporate could seek to improve its environmental impact by utilising proceeds to reduce greenhouse gas emissions, water pollution or improve energy efficiencies.

Are green bonds riskier?

Green bonds do not carry additional credit risk. The fundamental risks of the issuer continue to be assessed on the same basis as other bonds. Where the bonds are unlisted, investors should be compensated for illiquidity through an upward adjustment in the margin. There is, however, added operational complexity and costs borne by the issuer in respect of reporting requirements. One could argue that there is a slight decrease in credit risk due to the improved sustainability of the issuer’s operations as a result of the use of green proceeds.

Do they price differently?

The City of Johannesburg pioneered the issuance of green bonds in 2014. Recently, we have seen issuances from local financial institutions. In 2019, Nedbank’s first issuance of R1,7bn in April followed by R1bn in October were oversubscribed by 3x and 4x respectively. The proceeds were used to fund clean energy projects.

A comparison to other similar Big Four local bank issuances in the same month shows Nedbank’s green bond achieved a marginal improvement in spreads. This could be driven by various investor bid considerations. It is, however, unlikely that lower returns will be accepted for a counterparty’s green versus traditional bond unless there is a specific sustainable investment target.

Why consider green bonds?

Investor mandates and increased appetite for socially-responsible investing drives demand for green bonds as they place a specific requirement on the issuer in terms of the use of the proceeds, reporting principles and audit requirements. Earlier this year, Standard Bank issued its maiden USD200 million listed ten-year green bond. The entire issuance was taken up by the International Finance Corporation. The proceeds of the bond would be applied towards financing of eligible green assets including renewable energy, green buildings, water and energy efficient projects. [1]

In July 2020, African Development Bank announced a R2.05 billion investment in Nedbank’s ten-year subordinated green bond. The investment is expected to create more than 6 000 local jobs and promote financial inclusion, as well as catalyse further investment in renewable energy. [2]

The issuances evidence both lenders and investors commitment towards sustainable financing. Investors should be comfortable with the reporting principles or framework and the third-party verification so the intended consequences of the financing are achieved. Transparency in this regard will set appetite for further green bond issuances.

Benefits to the issuer?

Green bonds enable an issuer to broaden its funding base, attracting capital from a diverse and/or new funding base. It also enables the issuer to meet its sustainability objectives, provides brand equity and enhances its reputation as a responsible corporate citizen.

What are typical green bond tenors?

Green bonds are typically medium-term in nature but range from short-term to much longer dated bonds dependent on the underlying project or activity being funded.

Suitability for retail investors?

This depends on the reporting framework with retail investors’ ability to assess the credibility of the reporting and impact assessment possibly requiring a further measure of oversight.

Outlook

As the economy recovers and in further stimulation of it, we expect increased appetite for green funding driven by environmental, social and governance factors. Overall, participation in green bonds achieves climate investment objectives but not at the expense of investor returns.

[1] https://www.bloomberg.com/news/articles/2020-03-02/standard-bank-sells-200-million-10-year-green-bond

[2] https://www.afdb.org/en/news-and-events/press-releases/african-development-bank-concludes-r2-billion-investment-nedbank-sdg-linked-bonds-36712

www.ashburtoninvestments.com

JUST RETIREMENT LIFE: Expert Opinions: Edition: September / November 2020

With-profit annuities

– a good alternative investment strategy for retirees

While it is important to consider expected income growth over a long-term investment horizon, the annuity conversation generally starts with: How much monthly income can I secure?

 

There are two retirement options providing members with a sustainable income: a living annuity or a guaranteed life annuity.

When it comes to guaranteed life annuities, it is vital to consider both starting income as well as the expected income growth over a long-term investment horizon. Both these factors drive the value for money of a guaranteed annuity.

Guaranteed annuities can have set increase options to provide a known and reliable source of long-term income (non-profit annuities), or increases can be linked to the performance of an underlying investment portfolio (with-profit annuities).

The starting annuity income takes into account several factors like age and sex (which among other things largely determine life expectancy), purchase amount and any selected benefit options like a minimum payment or guarantee period, or spouse’s income.

While most of these details are static, it is important to note that there are market factors that also affect annuity rates.

Market variables affecting with-profit annuity rates

A with-profit annuity is a promise to a policyholder to pay an income (and increases) for their lifetime in exchange for a lumpsum investment.

To ensure the minimum guarantee can always be met, an insurer invests the assets it receives as part of this exchange in a cashflow-matching fixed interest portfolio and a multi-asset balanced portfolio, to which future increases are linked.

As a result, there are two aspects affecting the starting income of a with-profit annuity on a daily basis:

1. The yield curve (long-term interest rates)

2. Historical return of the underlying investment portfolio

For non-profit or fixed increase annuities, only the yield curve is considered because the increases are not linked to the performance of an investment portfolio. Earlier this year annuity rates spiked due to higher long-term interest rates, coupled with a fall in the underlying investment portfolios, which reduced future increase expectations and made annuities cheaper. This presented an opportunity for retirees to take advantage of cheaper guarantees to secure an income for life – a sustainable long-term solution with protection from outliving capital.

Choosing an annuity

On starting income alone, a fixed escalation annuity (or even an inflation-linked annuity) may look attractive compared to a with-profit annuity. But the income derived from a with-profit annuity can catch up and exceed fixed escalation income over time because it is linked to the performance of an investment fund, typically a balanced fund. The growth in income of a with-profit annuity can therefore better protect purchasing power later in life.

New generation with-profit annuities represent a high-yielding investment, and yields are locked in for life in the form of a sustainable income with no downside risk. And because increases are linked to the performance of a balanced fund, policyholders retain exposure to high growth assets at a lower risk due to smoothing protection.

www.justsa.co.za | info@justsa.co.za

021 200 0463

LIBERTY CORPORATE: Expert Opinions: Edition: September / November 2020

The importance of reviewing employee benefit structures

The Covid-19 pandemic and resultant lockdown have had a significant negative impact on the South African economy. As businesses alter their way of work in a constantly changing environment, they are also being driven to reconsider their business strategies.

While businesses reassess their approach and plans for the years to come, they should ensure that their employees’ total rewards structure currently in place supports their new or revised business strategy. If not aligned, then the total rewards structure for employees should also be revised to ensure that, in light of the pandemic, they remain appropriate and adequate.

A total rewards structure for employees is the structure put in place by employers not only to financially compensate their staff through a regular salary, but also to take care of them through providing employee benefits, and therefore additional financial and emotional support. In doing so, the broader wellbeing of employees may be looked after.

An employee’s financial wellbeing may be looked after by providing retirement solutions to help meet their retirement goals, and risk cover to protect them financially in the event of death, disability or illness.

An employee’s emotional wellbeing may be looked after by providing additional wellness solutions and services, such as emergency and support services. These also aim in assisting employees’ mental wellbeing.

It is critical for employers to look after employees’ wellbeing as business success is largely driven by the productivity and success of employees. Employers can play a vital role in employees’ lives by having solutions in place, such as risk cover and retirement solutions that can help them provide for themselves and their families, especially during this difficult and uncertain time. It means having benefit structures in place that align to the company strategy, incentivise employees and meet their needs.

Ensuring employees’ financial wellbeing through adequate retirement solutions

In many cases, employees’ retirement savings have been adversely affected by the pandemic. The adverse effect may be as a consequence of reduced salaries which have led to a reduction in retirement contributions. In other cases, it may be primarily due to the impact of financial market crashes, both locally and globally. Although there has been evidence of markets recovering, not all markets have recovered to the levels at which they were before the pandemic erupted.

Importance of reviewing retirement contributions for better outcomes

The Covid-19 pandemic has caused considerable financial distress for businesses. As a result, many retirement funds have put options in place to temporarily reduce or stop retirement contributions in order to help alleviate the financial strain.

While this may have provided employers and employees with immediate financial relief, it is likely to have an adverse impact on employees’ future retirement outcomes and ability to meet their retirement goals.

However, where a reduction or suspension of contributions has been implemented, employers can encourage their employees to make Additional Voluntary Contributions (AVCs) if they can afford to do so. Whether this is considered now, or in the future when affordability becomes more apparent, following the pandemic and economic recovery, communication and campaigns can be used to illustrate to employees how AVCs help to reduce the shortfall in retirement savings. This means educating employees on the positive impact that AVCs may have on their retirement outcome.

Ensuring employees’ financial wellbeing through adequate risk benefits

The pandemic and consequent lockdown have forced many employers to resort to different ways of working, to ensure that their businesses continue to survive and continue to support their employees. However, the speed at which this transformation has happened has also caused a fair amount of distress amongst employees.

In addition, the recent easing of some lockdown measures has caused employees’ fear of contracting the virus if they have been requested to return to work. This has caused stress, anxiety and depression for many employees, potentially impacting their long-term physical and mental health.

Risk insurance policies covering death, disability and critical illness are important for employees to have in place and may be even more crucial for both employees and their dependants during this difficult time.

The importance of having adequate death, disability and critical illness cover in place

With the aim of tracking the socio-economic impact of the virus, the lockdown and gradual re-opening of the economy, Ask Afrika, a South African market research company, interviewed a representative sample of 5 000 South Africans over an 11-week period during the lockdown. The results show that financial distress is the main cause of the negative impact on the health and wellbeing of South Africans. The fear that employees have of becoming unemployed has tripled during the lockdown period alone.

Many employers have allowed their employees to work remotely during the lockdown. Results from the research show that employees’ emotional distress is up to 10% higher for lower-income families compared to higher-income families due to having to balance a full-time job and household responsibilities at the same time. This has led to higher feelings of fear, depression, discouragement and irritability amongst the employed.

The research clearly illustrates that additional stress has been caused by the Covid-19 pandemic and the subsequent lockdown. This, as well as the impact of depression on both mental and physical health, may be significant. Mental health, specifically, is playing a significant role in the underlying cause for many adverse incidents.

Consequently, this may result in a greater chance of become ill or disabled. The effects of the pandemic have resulted in a need to review the level of risk cover provided to employees to ensure that an appropriate level of death, disability and critical illness cover is in place.

This will give employees peace of mind that they and their families are taken care of should anything happen during this highly uncertain time.

Ensuring employees’ emotional wellbeing during the COVID-19 pandemic

While employers review their retirement solution and risk benefit offerings as part of their overall employee benefits structure, it is also important that sufficient additional services are provided to ensure their emotional wellbeing, including their mental wellbeing.

A survey conducted by the South African Depression and Anxiety Group (SADAG) revealed that there has been a significant increase in the number of mental health issues observed since the start of lockdown, which have predominantly been as a result of increased stress and anxiety.

More specifically, the findings of the survey further demonstrated that the breakdown of the main challenges experienced by South Africans are as follows:

The underlying causes of these issues included job security and financial strain due to the pandemic. The global health crisis has created a number of challenges for many South Africans. As a result, a proactive approach to the emotional and mental wellbeing of employees may be required during

this period of increased uncertainty, emotional and financial strain.

Support through additional services

Many retirement funds offer additional support and emergency services. These can be provided to help employees improve their emotional and mental wellbeing. Solutions usually include services such as trauma counselling and emergency assistance. Another way to assist employees with emotional support is by providing educational tools to help their children. Liberty has partnered with Mindset to create the TenFold Education App which provides assistance with subjects such as Maths and Science, through tutorials and test papers for grades 10, 11 and 12.

It contains educational content aligned to the CAPS curriculum that is presented in a series of animated videos, providing explanations for a range of topics. The TenFold Education App can be downloaded from the Google Play Store and the App Store.

By providing additional services to employees, value is created for employers. It may be seen through lower absenteeism and improved mental health, as employees feel they are being taken care of. Support from financial advisers and benefit counsellors

Each individual’s circumstances are different. It is therefore vital that employers encourage their employees to speak to their fund’s financial adviser should they find themselves in need of financial advice. Employees also typically have access to benefit counsellors. Although benefit counsellors cannot offer advice, they can offer factual information to aid in decision making.

Considerations during this challenging time

With the economic outlook constantly changing, it is critical that organisations review their business strategies. It is also important that other elements such as total rewards structures be reviewed at the same time. This includes career and development opportunities and recognition programmes, but also includes the provision of retirement and risk benefits.

It is important for employers to ask themselves:

Should the benefits currently available to my employees continue as is, or should they be amended in light of the impact of the Covid-19 pandemic?

If financial relief options have been taken up to reduce or suspend retirement contributions, is there sufficient encouragement to my employees, who are not in financial hardship, to increase retirement contributions with the aim to help meet their retirement goals or desired outcomes?

• Should risk benefits be amended to accommodate increased risk of ill-health and mental instability?

Are my employees aware of any services that may be available to them to assist in helping their emotional wellbeing?

The success of a business is largely driven by the success of its employees. Therefore, looking after employees’ wellbeing is critical, especially in times of heightened uncertainty such as during the Covid-19 pandemic.

www.liberty.co.za

OLD MUTUAL INVESTMENT GROUP: Expert Opinions: Edition: September / November 2020

A HELPING HAND IN HOLDING INVESTEE COMPANIES TO ACCOUNT

Robert Lewenson leads ESG Engagement at the Old Mutual Investment Group. He is responsible for proxy voting and engagement, representing Old Mutual Investment Group on various industry bodies and championing responsible investment for the Old Mutual group.

 

ESG investment is a good thing. So what’s getting in the way?

1. The involvement required A number of compliance regulations have been introduced in South Africa in recent years, which, while not binding as legislation, serve to provide guidance and to encourage commitment to the recommendation that retirement funds have a requirement for environmental, social and governance (ESG) in their investment mandates to asset managers.

This compliance requires boards of trustees to study investment policy statements, ensure the sustainability of investments and to set out disclosure and reporting. In addition, they are required to be stewards of the assets in their members’ fund portfolios – a noble idea in principle, but requiring far more involvement than one would assume.

2. A lack of confidence on the part of shareholders Taking these requirements into consideration, it is no wonder that many shareholders lack the confidence to hold investee companies to account. In a poll conducted among 1 000 investors by The Share Centre, 79% said that they do not attend the annual general meetings of the companies in which they invest. A third said that they do not vote on company resolutions, while around six in ten said they don’t feel their vote makes any difference. This lack of confidence and reluctance to participate in the stewardship of client assets points to a gap in meaningful engagement on the issue of responsible investment.

So, what is the solution?

Old Mutual Investment Group (OMIG) has run a fully fl edged Responsible Investment

ESG investment is a good thing. So what’s getting in the way?

1. The involvement required

A number of compliance regulations have been introduced in South Africa in recent years, which, while not binding as legislation, serve to provide guidance and to encourage commitment to the recommendation that retirement funds have a requirement for environmental, social and governance (ESG) in their investment mandates to asset managers.

This compliance requires boards of trustees to study investment policy statements, ensure the sustainability of investments and to set out disclosure and reporting. In addition, they are required to be stewards of the assets in their members’ fund portfolios – a noble idea in principle, but requiring far more involvement than one would assume.

2. A lack of confidence on the part of shareholders Taking these requirements into consideration, it is no wonder that many shareholders lack the confidence to hold investee companies to account. In a poll conducted among 1 000 investors by The Share Centre, 79% said that they do not attend the annual general meetings of the companies in which they invest. A third said that they do not vote on company resolutions, while around six in ten said they don’t feel their vote makes any difference. This lack of confidence and reluctance to participate in the stewardship of client assets points to a gap in meaningful engagement on the issue of responsible investment.

So, what is the solution?

Old Mutual Investment Group (OMIG) has run a fully fledged Responsible Investment

(RI) unit for ten years, giving us a deep understanding that long-term system change requires alignment across the markets on core sustainability issues. The United Nations Sustainable Development Goals (UNSDGs) presents a workable framework to align the interests of society, capital providers, companies and governments. Considering this need for alignment, as well as the lack of meaningful shareholder engagement,

Old Mutual Investment Group has launched its Listed Equity Stewardship programme, which aims to drive positive ESG outcomes on behalf of clients – at both a company and a market level – that ally with the UNSDGs and serve as a basis for fostering greater industry collaboration.

No matter what ESG strategy is employed, stewardship is central to delivering long-term outcomes. Globally, we have seen an increasing number of large asset owners consolidate their stewardship activities to ensure a consistent outcome and expect that South Africa will be no different, with more active investors, bigger societal voice and stronger legislative enforcement, to support greater demand for stewardship services.

What can Old Mutual Investment Group offer?

We recognise the complexity of stewardship and offer a specifi c focus on RI and ESG. We built the RI unit and proprietary ESG screening models, and have automated most of the processes. As such, we have now built further capacity to offer the service to third parties, companies and asset managers alike. OMIG’s engagement activities with companies focus on key strategy and performance issues, such as: remuneration policy, climate change, audit quality, board succession, corporate governance, risk management, privacy and data security – to name a few. In 2019 alone, we interacted with 31 companies on 93 material ESG issues.

 

If you’d like to take this discussion further, or have any other investment-related questions, please contact us at futurematters@oldmutualinvest.com or visit oldmutualinvest.com

FUTUREGROWTH: Expert Opinions: Edition: September / November 2020

Credit as an asset class

Thato Khaole, investment analyst at Futuregrowth, continues the series on what trustees should ask their funds’ asset managers.

 

A good investment philosophy should keep an asset manager accountable by providing structure, while not inhibiting agility. While most asset managers would agree on the overarching principles, each manager has a unique investment philosophy and may apply it differently. This is why investors should become closely acquainted with their managers’ investment views and processes before handing over their hard-earned money to be invested. Here are some useful questions and discussion points when engaging your asset manager – about how it considers both listed and unlisted credit investments.

Futu How we reduce YOUR risk

UNDERSTANDING THE RESEARCH PROCESS

1. Describe a recent due diligence you have completed on a new borrower, including any red flags identified.

Key assessment areas:

– Depth of engagement, including the time and analytical resources dedicated to understanding the borrower’s operations, management team, historical performance, and any existing financial and non-financial risk mitigants in place.

– Responsiveness, or how risks were identified, interrogated by a credit committee and mitigated through factors such as legal protections, limits on deal size, and portfolio construction.

– Framework: Is there a due diligence framework in place, and is it appropriately and consistently applied?

2. What is the level of engagement with a borrower’s management team, both before investing and during the lifespan of the investment?

Key assessment area:

– Desktop review versus personal interaction. Integration of both desktop analysis and personal interaction aids interrogation of a borrower’s leadership character and strategic outlook.

3. What does your ongoing credit monitoring process look like?

Key assessment areas:

– Emphasis placed on macroeconomic and sectoral 1influences:

How do macroeconomic and sectoral views influence asset selection, risk pricing and portfolio construction?

– Spread views: If you are trading credit, you need to make sure it is priced correctly at any given time. In a recent example of the pricing lags that characterise the listed credit market, it took a defaulted borrower’s bond prices three weeks to fully reflect the borrower’s weakened credit fundamentals.

Therefore, investors should critically evaluate the manager’s monitoring of spread cycles, its spread view and its ability to price credit internally, should it believe pricing to be stale.

– Analytical team: What is the size, skill set and experience of the asset manager’s team?

– Frequency: How often are exposures and credit inputs reviewed?

– Process: What are the criteria for credit committee consideration versus delegated authority decision making?

– Incentive: What is the investment team incentive structure and is this aligned with your manager’s philosophy as well as your investor needs?

FAST FACT

The quantitative and qualitative factors that determine your credit quality are called the Three C’s of Credit. This framework highlights key categories a lender should assess in determining whether or not a borrower would be a good investment – Character, Capital and Capacity.

Character: Track record and trustworthiness of the borrower.

Capacity: The borrower has the financial means to repay the potential loan with interest.

Capital: The amount of personal financial resources the borrower puts towards the investment.

 

CREDIT VERSUS EQUITY

1. How do equity views influence credit decisions?

Key assessment area:

– Independence: As the prominence of multi-asset funds grows, it is not uncommon for managers to invest in several financial instruments across a borrower’s capital structure. It is therefore important that investors understand the processes in place that allow for independent and unconflicted decision making across asset classes.

2. In what ways does your credit process differ from your equity process, and in what ways are they the same?

Key assessment areas:

– Risk assessment and how that translates into pricing: Listed versus unlisted dynamics (such as the greater negotiating power usually available in the unlisted space) and emphasis of different financial metrics in the debt versus equity space.

– Monitoring: There is greater access in the public domain to information on listed companies versus unlisted ones, which can influence deal turnaround times. Listing requirements are also far more robust for listed equity than for listed debt.

– Consistency in the application of appropriate principles, such as how ESG risks are priced.

CREDIT RATINGS

An asset manager’s approach to credit ratings speaks to its ability to assess the probability of a specific borrower defaulting on its debt obligations. This, in our view, forms the basis for pricing credit risk in portfolios.

Official ratings are produced by credit rating agencies. These agencies serve as information intermediaries, collecting and assessing data on the relative credit risk of various borrowing entities – thereby theoretically reducing information costs for investors. Your manager’s models and assumptions may differ from – and supplement – the rating agencies’ methodologies, hence the benefit of having internal rating capabilities, too.

1. How do you use official credit ratings in your credit process?

Key assessment areas:

– Breadth: How many rating agencies are used?

– Emphasis: How much weight is placed on official ratings?

– Engagement: Desktop versus personal interaction with rating agency analysts and their methodologies.

2. What is your internal rating process?

Key assessment areas:

– Capability: Does the manager have rating tools to enable the assignment of internal ratings?

– Agility: How often are these ratings reviewed?

– Ability to hold a different view: Rating agency actions, historically, tend to be more reactive than proactive. In light of this, how do your manager’s internal ratings differ from those of rating agencies, if at all, and why?

ESG INTEGRATION

Futuregrowth has been on the journey of integrating ESG risks into our credit analysis process for the better part of the past 20 years.

We have observed that, if left unattended, Environmental, Social and Governance (ESG) risks will likely translate in some capacity into financial deterioration.

1. How are ESG factors integrated into your investment process?

Key assessment areas:

– Integration: Assess whether ESG is a fundamental consideration in the risk analysis process or not.

– Engagement: To what extent does your manager track ESG performance, have internal ESG expertise and/or engage

ESG research and experts as part of its credit analysis?

– Emphasis: How much weight is placed on ESG factors in making investment recommendations and pricing credit risk?

2. Describe recent engagements with borrower management teams regarding ESG risks.

Key assessment areas:

– Use of examples: Reference to specific examples can help you gauge if your manager’s previous responses regarding ESG have been applied consistently and how its approach has evolved.

– More than a checklist approach: While regulation such as

King IV sets out guidelines for achieving sound corporate governance, our experience is that many borrowers apply this regulation loosely, if at all. Therefore, investors need to evaluate the manager’s implementation of its stated ESG process and its interrogation of a borrower’s ESG data – as opposed to accepting it at face value.

– Recency: How often are ESG risks assessed, and when last did this happen?

SECURITY PRESERVATION

Credit assets are not without risk. Therefore, further to its ability to estimate the probability of default for an asset, the manager’s process should be probed around assigning value to the collateral provided against debt obligations and assessing a borrower’s loss given default

(LGD) – the portion of an asset that is written off if a borrower defaults.

1. How do you value the security provided against debt?

Key assessment areas:

– Independence: Is this security valued by the borrower or a qualified and independent third party?

– Critical analysis: How does your manager verify the valuations provided by the borrower?

2. Describe a recent example where you have needed to enforce security.

Key assessment areas:

– Insights: This question provides an opportunity to gather additional information on how distressed assets are handled.

– Legal robustness: The type of legal protections anticipated and incorporated when making a decision to invest may come to light here.

3. What factors do you consider when pricing for an asset that has security versus one that does not?

SELL DISCIPLINE

The ability to exit investments in an orderly, disciplined manner is just as important to the long term performance of your investment portfolio as the decision of which assets to buy. Your manager should therefore be able to update its investment thesis, remain objective should the original view no longer show value and recognise when it is time to move on.

1. Talk me through a recent sell decision or a security you are actively trying to sell.

Key assessment areas:

– Evidence of process: This question is particularly interesting in the current COVID-19 environment, as liquidity in listed and unlisted credit has reduced significantly, requiring managers to adopt a temporary buy-and-hold strategy.

– Agility: Engagement with risk-reward dynamics.

– ESG: Is this considered as part of selling decisions?

DISTRESSED ASSETS

1. How do you currently manage distressed assets and debt restructures?

Key assessment areas:

– Level of support: Single analyst versus a team of individuals, as well as the extent to which additional upskilling is provided.

– Engagement: How much analytical time is currently spent on distressed debt and debt restructures?

2. Discuss one of your worst performing credit investments.

Key assessment areas:

– Accountability: The extent to which your manager takes responsibility for the investment choices made.

– Actions taken in relation to the exposure, both prior and subsequent to the investment deterioration.

– Learnings: The ability to take learnings forward.

3. What aspect of your sell discipline didn’t work effectively in the aforementioned investment?

Key assessment area:

– Consistency: Do they do what they say?

TO WRAP-UP

An asset manager’s investment philosophy should be consistent and structured in such a way that ownership, incentives, teams and fund capacity are aligned. Due diligence is not something that is done before the initial point of investment and then forgotten. A good manager should be able to provide proof of consistent application of its stated philosophy. This is something investors should ask for and evaluate periodically. At the end of the day, you are paying for your manager’s process. It is the engine used to both grow and protect investor capital. Therefore, your manager should be able to provide examples of when its process succeeded, failed and was improved.

Futuregrowth Asset Management is a licensed discretionary financial services provider.

www.futuregrowth.co.za

MOMENTUM INVESTMENTS: Expert Opinions: Edition: September / November 2020

ESG no longer only a ‘nice to have’

It’s become an essential ingredient in making decisions, argues Momentum Investments deputy chief investment officer Mike Adsetts.

 

An up-and-coming generation, which is well educated and interconnected, is one of the demographic forces for why ESG (environmental, social and governance) investing, also known as responsible investing, is gaining focus.

The recent high temperature in the aptly named ‘Death Valley’ in California of 54,4°c on 16 August, with the public outcry on the effect of global warming that followed, is yet another example of how the intent behind

ESG is becoming far more tangible. At a recent conference, one of the topics was whether there are good examples of how ESG can create real effect.

An effect can be real yet unrecognised if it is too far away from the observer. This was one of the main criticisms of the early wave of ESG initiatives, where there was a lot of focus and work on governance. If you look at the level of corruption endemic in the state at the moment, it is clear that good and clean governance is critical and that the failure thereof can be catastrophic.

However, it seems impossible to grapple with how to make a real difference as an individual, voting with your savings or investments. To make this more real, there is no better example than the built environment to demonstrate that ESG can have a real effect in people’s lives and that individuals can participate in this. It’s so powerful because the evidence is tangible. When you walk into a space you can see and feel that the effect of ESG is real.

Unpack these three letters. Think of the ‘E’ as supporting investments that do not damage the environment, which is one of the driving forces behind the adoption of renewable energy; ‘S’ as beneficial to communities, such as retraining staff, when new technologies are introduced in a company; and ‘G’ as making sure there are checks and balances in a system, such as independent procurement processes to mitigate corruption.

As a business, Momentum Investments has a proactive and integrated approach to ESG. An example of how we invest our clients’ money is in rural commercial infrastructure. The development of Taung Mall in the North-West Province directly, per our assessment, created around 100 jobs without considering the multiplier effect of business activity that surrounds this centre.

It has a real effect in people’s lives. The critical power situation that our country has also presented an opportunity with the installation of solar power and batteries, at these and other commercial properties, affording an attractive return in a cleaner, more energy-efficient manner as well as providing power security to the centre.

Another area of opportunity, though not without its challenges, is that of infrastructure development. Depending on how you approach this, you can reach very different perspectives. Taking into account the current noise around prescription or compulsory investment by retirement funds, you can easily conclude that these investments are a very bad idea. The reality, as always, is far more nuanced.

In May 2020, government announced that it is in the process of fast-tracking R350bn of infrastructure projects. This is part of government’s overall Covid-19 response to restart the economy and crucially requires private-sector investment to make these projects happen.

Looking at the project pipeline, it yields a mixed bag that has vastly different levels of attractiveness and indeed an effect from an ESG perspective. The full pipeline is unlikely to excite all private investors but the focus on critical water and energy as well as transport infrastructure is a bright spot of the project pipeline. Many of the projects in these categories also have the added benefit that they really will make a meaningful difference and have beneficial ESG effects.

ESG is an area of investment that warrants an increasing focus. It represents an approach to investing that looks at issues more broadly than from a pure profit or economic perspective.

Our approach to investment management explicitly acknowledges the relevance to the investor of ESG factors and of the long-term health and stability of the market as a whole. The generation of long-term sustainable returns is dependent on stable, well-functioning and well-governed social, environmental and economic systems.

The key thing is that, for ESG to move from the perception of a good idea and nice-to-have, the real effect of these three factors must be highlighted. As clients make decisions on how to allocate and invest their capital, they can move from not only doing well but also doing good.

https://www.momentum.co.za/momentum/invest-and-save