How to build a sustainable credit portfolio

Attractive risk-adjusted returns are as much of a priority for those of us managing a sustainable portfolio as for any manager in our peer group. But However, we do take a different approach. Here are five principles we recommend for making credit portfolios more sustainable.

1. What does best in class look like? (Context is key)

In sustainable investing, it’s crucial to be able to navigate nuance, and investors need to think about “best in class” in relative terms. For example, the hotel industry is relatively water and electricity intensive, but within that sector some companies are taking credible steps to address the challenges. Another example: companies with emerging market supply chains have had more controversies than those that don’t. This doesn’t mean avoiding those companies. It means investors need to understand the real-life context. For example, we are invested in a clothing company that has much of its supply chain in Asia and (we believe) is being credibly proactive in areas such as responsible cotton, stakeholder engagement and diversity.

2. Adding alpha by identifying improvers

We want to own best-in-class companies, but we also focus on finding the companies that have potential for improvement. They may not be quite there yet, but we can work with them to get more disclosure and transparency, to the point that we are confident enough to invest. If you invest early in a company that is moving in the right direction, this can provide diversification and long-term alpha opportunities.

Improvements in governance, in particular, are a good indicator of financial value as well as sustainability. Companies that are smart about prioritising limited natural resources and working with their stakeholders tend to have lower financing costs and less fluctuation in their business plans.

3. Engagement: combining research and relationship

Active engagement requires us to know the company’s business model inside out and understand the context it is working in. Financial and sustainable considerations tend to intertwine. For example, our holdings include the owner of a budget hotel chain that is expanding in Europe. In a recent engagement, we discussed the importance for the issuer to maintain its investment-grade rating by keeping its leverage down. We also talked about its plans to use renewable energy in its new hotels, which has the added commercial advantage of giving the company better control over its energy bills.

4. Keys to a Paris-aligned portfolio

To achieve an overall portfolio temperature of less than 2°C, it is important to assess the current state as well as confirming direction of travel. First we look at a company’s current emissions. Then we evaluate how rigorous its targets are for reducing emissions, what resources are being allocated to meeting those targets and whether the company is on track to meet them. Some of the information comes from external databases like MSCI which give an idea of the implied temperature rise of the company, but much of it is bottom-up analysis and direct discussions with management. Investors need to look not just at scope 1 and 2 emissions but also scope 3, to capture greenhouse gas emissions upstream and downstream throughout the supply chain.

5. Designing intelligent exclusions

A good exclusion list takes more thought than many people realise. There are a number of ways to screen out issuers and sectors which are harmful to the environment and society, and investors need to decide on when to use outright exclusions and when to set limits on revenue earned from harmful activities. At the country level, data from entities such as Freedom House and Transparency International help screen out countries with low levels of human rights and high levels of corruption.

With exclusions, there will inevitably be times where the portfolio will underperform because you don’t own certain names. But in the long run we believe exclusions do more good than harm. From a risk management perspective, for example, sustainability-driven portfolios can be less volatile.

A version of this article appeared first in Citywire Magazine