As we have written previously, current market dynamics have caused us to constantly revisit our views of where investors can seek shelter, perhaps more so this year than most.
That said, 2022 so far is but a subset of an extraordinary last two to three years that can only be described as eye-opening at best and volatile at most.
However, while operating conditions continue to change, it is comforting to know that the reliability of key credit fundamental influences remains. While we have touched on certain credit fundamentals, we highlight the more subjective but perhaps the most important aspect of governance within credit analysis that is rising in prominence.
Mapping the journey
In the context of the direct and indirect aspects of the Russia-Ukraine conflict, we previously highlighted: (1) The importance of a strong and defensible market position to help corporates pass on higher costs to their customers; and (2) A conservatively leveraged balance sheet and/or strong liquidity through either stable cash flows from earnings or access to committed external financing. These key aspects of business and financial risk analysis can be best exemplified with the concept of driving a car:
• Business risk analysis defines the environment along which the car is driving and the car itself through the appropriateness of the car model (business-specific factors such as product and geographic diversity, competitive advantage and market position) for the conditions in which it is driving (for example, the weather and the road through country, and industry risk). This means, business risk analysis sets the scene for what’s down the road.
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• Financial risk analysis seeks to identify how much fuel is in the tank through how much cash the issuer makes from its operations (profitability, cashflow), how much cash the issuer has (leverage), how much cash the issuer needs to keep things going (maintenance/growth), and how can it cover any gap that exists (liquidity). In other words, financial risk analysis quantifies how far down the road the car can go.
Who is behind the wheel?
Having clear roads, the latest car model and a full tank can mean nothing if you do not have someone experienced and proficient behind the wheel. It can mean that a car may run into trouble earlier than expected, meet with an unforeseen accident, or fail to even start. This is where the analysis of ownership and management influence comes in. Key aspects of this subjective component of business analysis include the capability of management, through their experience, and the thoroughness of its strategic plan.
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Questions to consider include:
• How achievable or aggressive are management’s strategic plans and do they fit in with the issuer’s core competencies?
• What is management’s track record in achieving its previously stated objectives?
• Have there been any corporate governance issues of note?
• Finally (or perhaps consequentially), does management maintain a good relationship with banks/capital markets (equity issuance or bond issuance) so that it can access external funding when it needs to?
While we strive to assess the influence of ownership and management as we do other more fundamental aspects of credit analysis, its impact on the outcome is not uniform and the score may not explicitly alter the outcome of our overall Business Analysis. This is because a positive or neutral assessment for higher grade credits is unlikely to improve the overall business assessment.
Conversely, a somewhat weaker assessment of ownership and management for higher-yielding credits can weigh on the overall business assessment, particularly if management is: (1) Weak and/or exposes the issuer to agency problems; or (2) Owners/management have acted or continue to act in a credit negative way. These can ultimately impact the financial analysis as a negative view of ownership or management by capital providers can strain liquidity.
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Amplifying influence of ownership and management with the rise in “ESG” Investing
The rise of Environmental, Social and Governance (ESG) investing has been well documented. According to data compiled by Bloomberg, 2021 green, social, sustainability and sustainability-linked (GSSSL) bond sales from government and corporates totalled US$1.096 trillion, which was around 93% higher y-o-y. That said, GSSSL bonds have not been insulated from current challenging market conditions — year to date, green, social, sustainability and sustainability-linked bond sales from government and corporates total US$318.9 billion ($440.92 billion), which is around 13% lower y-o-y than the same time last year.
Within this, however, environmental and social issues have taken centre stage. Of the GSSSL bonds issued in 2021 and 2022 to date, around 51% are green bonds, around 19% are social bonds and around 30% are sustainable or sustainability-linked bonds. Part of this may be due to investors’ clearer understanding of these issues and the ease of assessing these aspects of ESG investing to meet targets.
Even within these categories is some dispersion in issuance. Year to date green bond sales total US$162.4 billion in 2022, down around 4% y-o-y while year to date, social bond sales total US$49.4 billion, down around 52% y-o-y. This indicates the somewhat temporal nature of social issuances that could be tied to the easing pandemic situation globally.
So, does this make governance a less important component of ESG investing? Arguably not because the same principles mentioned in our discussion of fundamental credit analysis continue to hold true. Governance drives the quality of the decision making that influences an issuer’s environmental and social and overall sustainability performance.
Indeed, goal 16 of the United Nations Sustainable Development Goals (SDGs) titled “Peace, Justice And Strong Institutions” recognises that “We cannot hope for sustainable development without peace, stability, human rights and effective governance, based on the rule of law.” Poor governance not only has sustainability and human consequences — there have been many instances in the past where it has also led to direct and indirect financial consequences for issuers and recognition of heightened credit risk.
In March, Japanese automobile manufacturer Toyota saw its shares fall markedly after its commercial vehicle subsidiary, Hino Motors (Hino), admitted to having manipulated and cheated in its diesel emissions tests. Following this, Hino suspended sales of its trucks and buses that were equipped with the problematic engines in question. Hino saw its share price fall 17% on the back of the disclosure. Moving forward, Hino has committed to conduct a thorough investigation of its engine certification procedures and will take corrective measures following in-depth analysis and reform.
Archegos Capital Management (Archegos) continues to have impacts on Credit Suisse Group AG (CS), one year after it first disclosed that it may face significant losses related to Archegos that defaulted on margin calls. So far, CS has raised well over US$4.4 billion in provisions, dealt with significant management turnover and staff departures, increased expenses and lower revenues tied with a material corporate restructuring and higher compliance investment.
In CS’s recent Annual General Meeting, shareholders voted not to absolve the bank’s board from legal liability for errors that may have led to losses from Archegos. Voting to protect the right to pursue legal liability could mean legal issues for CS will continue to be an overhang. The Employees Retirement System for the City of Providence is currently pursuing legal proceedings by suing CS’s current and former board members for alleged risk management failings over the collapse of Archegos.
While we believe that the influence of Governance on ESG investing will continue to rise, its influence on issuers and GSSSL issuance will remain indirect. This is due to the primary influence of governance concerns on investor perception and an issuer’s reputation from both a fundamental and sustainability standpoint.
Turning something subjective into objective
Assessing management, ownership and governance can be difficult. While adverse regulatory judgements and penalties or legal proceedings indicate underlying corporate governance issues, the existence of them is similar to a sunk cost for an investor.
At the same time, their absence does not necessarily mean that such issues will never surface, as it is no guarantee that governance issues will not arise in the future. Going back to the earlier analogy, the challenge, therefore, lies in accurately assessing the drivers’ skills in different driving conditions before an accident can happen. Doing this entails turning the subjective assessment of management, ownership and governance into an objective one.
The ongoing development of the quality and quantity of disclosures in the ESG investing space can help in this regard. A possible solution lies in one of the key targets of SDG16 where it relates to Governance — developing effective, accountable and transparent institutions. Effectiveness can be assessed by looking at management’s past strategic plans and their success in achieving them. Accountability can be sourced by looking at the remuneration policies for key employees (according to the United Nations’ Principles for Responsible Investment, more companies continue to announce the linking of executive pay to their firm’s ESG performance).
Finally, transparency can be assessed by the quality and quantity of the issuer’s disclosures, something that investors and all stakeholders are becoming increasingly vocal about given the rising importance of governance within ESG Investing.
Andrew Wong, Ezien Hoo, Wong Hong Wei and Toh Su-N are credit research analysts at OCBC Bank’s global treasury research & strategy
