A sustainable roadmap

Nachu Chockalingam, senior credit portfolio manager, Federated Hermes talks to Shanny Basar about change, curiosity and criteria.

When Nachu Chockalingam, senior credit portfolio manager, joined Federated Hermes in London in 2018 sustainability was not very mainstream but asset managers have changed their business models in a very short period of time.

Chockalingam said, “You can achieve a lot of good things if you’re mobilising capital in the right way to achieve positive outcomes from a financial and an environmental, social and governance (ESG) perspective. So you can make a real difference.”

She continued that in the last couple of years investors have been demanding more from asset managers in terms of the type of ESG products that are created and sold, but also in terms of the data and analytics that are reported back to them.

“They want more case studies and data around how our funds are performing on a relative basis on sustainability, as well as financial metrics,” Chockalingam added.

Federated Hermes does not see financial and sustainable objectives as being mutually exclusive but instead sees them as two co-linear objectives that are self-reinforcing. “Sustainable companies can have strong financial and operating profiles, which in turn supports their investment performance,” explained Chockalingam.

The asset manager has launched the credit desk’s first funds with dual financial and sustainable objectives. The first objective is to deliver a positive financial return on a relative basis and the secondary objective is to show enhancements in sustainability.

Chockalingam is co-portfolio manager of two Article 9 funds – the SDG Engagement High Yield Credit strategy, which launched in 2019, and the Climate Change High Yield strategy which debuted last year. Under the European Union’s Sustainable Finance Disclosure Fund (SFDR), an Article 9 fund needs to meet specified requirements in order to reach their objective of either sustainable investment or a reduction in carbon emissions. She is also the sustainable portfolio manager for a range of flexible credit strategies.

The Climate Change fund was launched last September and has more than doubled in assets in the space of four months according to Chockalingam. She said, “We are thinking about other products that we can potentially bring to market which have alternative sustainable themes.”

Sustainability had been on Chockalingam’s radar for a while and her interest was enhanced in her previous role at the Ontario Teachers’ Pension Plan in Canada. Teachers’ which did a fair amount of direct lending.  Chockalingam said it became very apparent that the pension fund needed to assess issuers’ ESG risks, particularly for instruments that were not very liquid.

“Working for an asset owner like the Ontario Teachers’ Pension Plan gives you a different perspective,” she added. “Pension funds are much better sometimes in thinking long-term and can stomach more volatility in the interim.”

The Climate Change High Yield Credit Fund, seeded by and designed in partnership with Swedish National Pension Fund AP1, aims to achieve a lower carbon footprint than the benchmark. The SDG Engagement fund commits to engage with 100% of companies in the fund in order to make them have a greater positive impact on society and the environment and help achieve the United Nations’ 17 Sustainable Development Goals.

Federated Hermes has developed internal proprietary tools to make sure the funds are on track to meet their secondary objective. For example, in the Climate Change fund each issuer is assessed on an individual basis by measuring its carbon footprint versus the broader benchmark.

The 2020 annual report for the SDG Engagement High Yield Credit fund was published in April last year and said 353 engagement actions were carried out at 114 companies with EOS, Federated Hermes’ stewardship service provider. In 2020 the strategy returned 7.93% in US dollar terms, gross of fees, which was 136 basis points ahead of the benchmark index for the period.

Credit spectrum
Both funds generally focus on the higher-quality spectrum in the high-yield universe, around the BB-rated area, as the desk believes that focus works well and there is a lot of opportunity to extract positive value.

Chockalingam said, “Right now, in the high-yield market, unlike in the investment-grade market, fewer investors are as focused on sustainability as us. That means our clout tends to be higher and companies are really wanting to benefit from our insight and knowledge on how they can become more sustainable in investors’ eyes.”

In addition, she highlighted that these companies tend to be bigger, are often publicly listed and have larger capital structures which creates a recurring need to access financial markets. “Active security selection is one of our key ways of generating alpha in our portfolios,” she added.

In high yield, Federated Hermes’ core investable universe is approximately 650 to 750 names, which are mainly the highest DTS [duration times spread] contributors to the benchmark. Chockalingam stressed that the end goal for the firm’s clients is to achieve the positive dual objectives and not to forsake returns in order to deliver more sustainable products.

“Our analysts assess the credit fundamentals of those companies irrespective of their sustainability objectives as the credit must stand up for itself,” she said. “The fundamentals of credit strength are really important for us to get right, and if that works, we can move on to assessing sustainability and the potential for that particular issuer.”

ESG integration
At Federated Hermes the desk had integrated ESG into its credit process for many years before Chockalingam joined, but she explained that the process has been enhanced and refined over time. She believes ESG data is improving, especially as investors are putting pressure on companies to provide information more quickly.

Even in high-yield, Federated Hermes has seen more companies voluntarily disclosing data which is the first step towards properly assessing the ESG credentials of an issuer.

“There is a lot more data but it’s really a case of having people who are experts in terms of analysing and assessing that data, to make sure we have picked the right credits to go into our funds,” said Chockalingam.

She noted that in order to address concerns about greenwashing, it is really important to analyse the details of the security that you are buying from a return perspective, as well as a structural perspective.

When assessing a company’s sustainability credentials and pathway Federated Hermes first assesses the information that the issuer produces. The asset manager then reviews the plethora of third-party ESG data that is now available but does not purely rely on this information. Most of the third-party data is published for companies that have public equity and may not be mapped correctly for fixed income. In addition, third-party data can be backward-looking with a great deal of dispersion between different providers.

As a result, Federated Hermes assesses third-party data holistically before applying its own qualitative overlay, encompassing the insight the firm gains from engaging with companies.

Chockalingam said, “This essentially makes our assessment more reflective of the company’s current situation and what we think is most likely going to happen in the future from a sustainability point of view.”

Regionally, she highlighted the stark difference between how much further ahead European companies are versus the US and emerging market companies in thinking about sustainability. However, Federated Hermes expects this will be fairly short-term and that over the next five years US companies will have caught up, and this will then transition more broadly into emerging markets.

“Interestingly, in some sectors emerging market companies are actually the leaders right now, i.e. pulp and paper, where we are very encouraged by progress that has been made by the leading Brazilian companies in the sector,” she added.

Once the desk finds a company that it likes, it looks through the issuer’s entire capital structure to assess the best place to be positioned at a point in time. Chockalingam described Federated Hermes as very active in terms of managing risk exposure and may shift from bonds to credit default or loans.

The entire fixed income market is waiting for central banks to raise interest rates. As a result, overall management of duration is key according to Chockalingam and the desk has progressively reduced duration over the past six months. In addition, the desk is not overly exposed to companies reliant on big growth.

“Our companies are fundamentally sound, have strong cash flows and balance sheets and, in some instances, are considered to be rising stars,” she added.

Last year many companies took the opportunity to pre-fund some of their short-term maturities. As a result Chockalingam believes there will be less primary issuance this year, which will alleviate some of the pressures that companies might face.

Green bonds
Sustainable finance bond issuance was more than  $1.0 trillion for the first time last year, an increase of 45% from full year 2020, according to data provider Refinitiv. In addition, green bond issuance last year was a record $489bn, nearly double 2020 levels, and the number of issues surpassed 1,000 for the first time.

Federated Hermes has been grappling with the concept of a ‘greenium’ in the debt market. A greenium is when, in many cases, greater demand causes green and other sustainability-linked bonds to trade with a lower yield than non-labelled bonds from the same issuer. AFME’s European ESG Finance report for the third quarter of last year found  that ESG corporate premia tightened from nine basis points in April 2020 to an average of one basis point between April and November 2021.

Chockalingam said, “Sometimes we think investors should buy the non-labelled bond and essentially pick up that extra yield rather than buying the labelled bond which is trading at a premium, especially if we are constructive on the fundamentals of the company and its sustainability trajectory.”

Some sustainability-linked bonds have set key performance indicators with step-ups in coupon payments if the KPIs are not met. However, there have been market concerns that many of these targets are not stretching enough.

“Investors need to really assess the language behind those KPIs and make sure they are comfortable with the compensation that they will receive if the KPI is not met,” added Chockalingam.

She believes sustainability is becoming broader in fixed income as sustainability is moving into private debt and more structured credit after starting in credit. Chockalingam does not think that just ESG integration will be a differentiating factor in five years time.

“The differences between asset managers will shift to how well they integrate ESG into their investment processes, how well it is embedded in the culture of the firm and how well an asset manager has adapted to the data, technology, tools and intellectual capital that is available and how much their approach is proprietary,” she said.

Career
Chockalingam graduated from the London School of Economics with a degree in Economics and is a CFA charterholder. Her career began at JPMorgan in London where she spent 13 years covering European high yield and investment grade and then CEEMEA credit.

“I really enjoy markets,” she added. “I like the fact that every morning I have no idea what the day is going to hold and that is really exciting.”

In 2013 Chockalingam and her husband moved to Canada where she worked for the Ontario Teachers’ Pension Plan. They decided to move back to London to be closer to family and have greater support after they had two young children.

“I have known my current manager for close to 15 years and timing for both him, Federated Hermes and me worked in terms of facilitating the move,” added Chockalingam.

Her experience at the Canadian pension plan helped her transition to a global credit desk at Federated Hermes.

She said: “At Teachers’ I was very lucky to work for an organisation that thought about global opportunities. I was given the opportunity to look at North American credit for the first time, to supplement my previous background in looking at European and emerging market credit.”

Chockalingam puts her success down to her curiosity to learn and work with different experts in their fields. For example, she has really enjoyed working on the dual objective funds as she works with people who are not finance professionals, but are sustainability professionals.

“I’ve learned a lot from talking to and working with them,” she added. “We can achieve great things if we continue down this pathway because there is clearly an investor appetite for the world to change and become more sustainable.”

She would tell young women that finance is a fascinating, dynamic industry. “They should take it to heart and run with it,” she said. “You can achieve a lot in our industry if you put your mind to it.”

However, the industry needs to be better at attracting and explaining to young people what the career entails, how much impact can have as an investor and do better at encouraging more young girls to think about finance, and investment management, as a career option. When Chockalingam talks to young people, she finds they are very much interested in a career in finance but often do not know how to get in.

“One thing that asset management is learning from banking is that recruiting women early in their careers and giving them exposure to this industry is a good thing to do,” she said. “Slowly but surely the bigger asset managers are doing that, but we also have to think about how to retain women and bring back women who have potentially left the workforce.”

Chockalingam believes the option to work from home makes a massive difference in helping attract more women. She said: “I have young kids and a hybrid working model really does make life a lot easier for me personally, although it may not be for everybody.”

©Markets Media Europe 2022

 

 

 

 

 

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