The COVID-19 pandemic is a devastating global crisis with massive social, economic and governance implications. But, the risk of a global pandemic was not completely unexpected. Bill Gates, the founder of Microsoft Corp, said in a TEDx talk in March 2015, “Today, the greatest risk of global catastrophe…is most likely to be a highly infectious virus rather than a war, not missiles but microbes.”1 JP Morgan, in a recent report, labels the COVID-19 crisis as a Gray Rhino. Playing off the Black Swan cliché, a Gray Rhino2 is a high impact, high probability event that remained a neglected risk.
As the COVID-19 pandemic stalls the global economy and social distancing has become the norm, we are forced to confront its devastating effects. We are also presented, however, with an opportunity to evaluate the crisis as it emerges and its implications for corporate bond investing. Additionally, the crisis is shedding light on corporate environmental, social and governance (ESG) practices and management priorities.
We believe this crisis, as in others’ past, highlights the importance of taking a long-term, with ESG factors, view when analyzing the credit quality and resilience of a corporate bond issuer. This is a foundational research principle for Breckinridge. Although the ramifications of this crisis were impossible to foresee, management decisions about long-term strategy, a well-defined and prudent capital allocation policy and diligent Board of Directors’ oversight can dramatically influence how a company operates during periods of distress. In our research, we seek to invest in companies with management teams that understand that a benign operating environment will not last forever. Their plans will reflect long-term challenges, risks and costs. As a supporter of the CECP Strategic Investor Initiative, we also encourage companies to make their long-term plans public.
Second, and it is connected to the first, we believe that the market may take future tail risks more seriously than in the past. As the world severely adjusts to the economic realities of COVID-19, market actions in March rivaled those experienced during the Global Financial Crisis (GFC). At its core the GFC was a failure of corporate governance and perhaps a systemic inability to believe that U.S. real estate prices could decline nationally even if they had not done so since the Great Depression.3 Another example of how markets have typically not priced in outlier, low probability events. We believe that will change.
In the post crisis environment, we believe companies with characteristics like a clearly defined purpose and a prudently managed balance sheet, and where decisions are made with a broader set of stakeholders in mind are more likely to be sound, long-term investments.
Our research approach emphasizes fundamental credit analysis that incorporates a systematic assessment of ESG considerations. We believe ESG integration enables deeper insights into the underlying risk and relative value of an investment. The U.S. has experienced twenty-one recessions in the twentieth century. There is evidence that corporate governance lapses are more prevalent during these periods.4 Accounting write-downs are more frequent in recessions as financial assumptions underlying mergers become more difficult to deliver on. The honesty, quality and integrity of management is crucial and when it is severely lacking then bondholder losses may ensue.5 For diligent financial analysts, we believe that material ESG data can offer a lens into the quality of management. As JP Morgan recently notes, we are experiencing “a systemic crisis which will have a profound economic, social, and environmental implications which may question corporate governance in the short, medium and long term.”6
With the plunge in economic activity brought on by the crisis, the corporate research team shifted much of its analytical focus to near-term considerations. The customary emphasis on long-term value creation was temporarily diverted to assess the consequences of a marketplace with significantly weakened demand. Analysts are currently stress-testing and evaluating the liquidity profile, capital structure and free cash flow capabilities of companies under coverage. A keen focus on financial strength can position a well-managed company for long-term capital investment sustaining operations, market positioning and stakeholder well-being.
Our research analysts are also paying attention to how companies and senior management are responding to the unprecedented financial and operational challenges brought on by this crisis. We are evaluating how those responses can illuminate potential ESG risks and, ultimately, credit quality. As part of that effort, we inquire during engagement discussions about ESG factors that may be affected by the crisis, including a company’s board and governance structures, human capital, supply chain and regulatory strategies. Issuer engagements factor into current and long-term views on a credit.
Just as the GFC revealed lapses in bank risk management, an over-reliance on risk models and a lack of sufficient financial acumen at the Board level,7 we believe this crisis is revealing a new dimension for ESG research. Morgan Stanley noted in a recent report on COVID-19 and ESG investing that “human capital management, corporate culture, and the treatment of customers are key factors in ESG investing. In a time of massive disruption from COVID-19, corporate responses around these issues can have lasting impacts.”8
The importance of management decisions affecting employees, customers, and communities is being highlighted by conditions dictated by the virus. As with other ESG factors, the level of materiality will vary across sectors as the world responds to crisis. Morgan Stanley notes that variables will include “changes in product demand, government-mandated shutdowns, type of workforce (e.g., hourly vs. salaried), and employees’ ability to work remotely” as well as level of fiscal policy support.
The premise of factoring in ESG materiality is based on a view that decisions made during the virus response will reflect bond issuers “that successfully adapt in a dynamically changing environment, while operating in ways that maximize the benefit (or minimize the disruption) for all of their stakeholders, could realize long-term competitive advantages,” according to the report.
Decisions made by management teams may reveal preparedness and resiliency, as well as long-term measures of their commitment to sustainable operations. Studies show the long-term implications for productivity and financial performance that human capital decisions can have on employee satisfaction and workplace culture.
Decisions about treatment of customers and efforts to provide aid and solutions around COVID-19 may determine the value of brand equity and whether customer relationships benefit or suffer. Intangible assets (e.g. intellectual property, patents, trademarks, goodwill, brand value) for S&P 500 companies were valued at just over $20 trillion in 2018.9 Intangibles are challenging to value and subject to annual impairment tests. Management teams that hurt brand value through their actions in this crisis and/or those who may have over-paid for assets during the merger boom are at risk for future asset value write-downs.
Breckinridge initiated its ESG research as part of our credit risk analysis almost a decade ago. Breckinridge integrates ESG research across our assets under management and offers clients a range of specifically designated sustainable strategies that emphasize ESG. We believe that the sustainability lens, ESG research and a careful approach to credit risk helps us to build resilient bond portfolios.
Nicholas Elfner – Nick, senior vice president, is co-head of research at Breckinridge. He is a member of the firm’s Investment Committee where he is jointly responsible for setting the firm’s investment outlook and the translation into portfolio strategy. In his role, Nick heads Breckinridge’s corporate research efforts and performs corporate credit analysis and contributes to the ongoing development of Breckinridge’s environmental, social and governance (ESG) frameworks.
Robert Fernandez, CFA – Rob, vice president, is Breckinridge’s director of environmental, social and governance (ESG) research. He is also a member of the firm’s Sustainability Committee. In his role, Rob leads Breckinridge’s ongoing ESG integration and engagement efforts, regularly contributes thought leadership and performs corporate credit analysis.
 Gates, B. The next outbreak. We’re not ready. Retrieved from: https://www.ted.com/talks/bill_gates_the_next_outbreak_we_re_not_ready?language=en#t-65201
 Hecker, J. et al. (2020, March). Stay safe and think long term. JP Morgan Cazenove, pg 3.
 Mirvis, T. (2010, February). Corporate Governance and the Financial Crisis: Causes and Cures. Of the 15 S&P 500 companies with the worst-performing stocks in 2008, 80% did not have staggered boards, 80% did not have a poison pill in place and 73% had majority voting or a director resignation policy.
 Valukas, Anton R. White-Collar Crime and Economic Recession. University of Chicago Legal Forum, Vol. 2010.
 Stanford GSB Staff. What Led to Enron, WorldCom and the Like? Stanford Business School, October 15, 2003
 IBID, pg. 3.
 Kirkpatrick, G. The Corporate Governance Lessons from the Financial Crisis. Financial Market Trends, OECD 2009.
 Savino, M. (2020, March). COVID-19: Effects on Employees, Productivity and Corporate Reputations. Morgan Stanley
 Ross, J. Intangible Assets: A Hidden but Crucial Driver of Company Value. Visualcapitalist.com, February 11, 2020.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions.
While Breckinridge believes the assessment of ESG criteria can improve overall credit risk analysis, there is no guarantee that integrating ESG analysis will provide improved risk-adjusted returns over any specific time period.
Some information has been taken directly from unaffiliated third-party sources. Breckinridge believes such information is reliable but does not guarantee its accuracy or completeness.
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