1. Green Sky Thinking

    THE BAILLIE GIFFORD HIGH YIELD BOND FUND

    Lucy Isles, Investment Manager. Second Quarter 2018
  2. Managing risk is the crux of High Yield investing. Our job is to select good investments and mitigate the risk of price decline or, worse, default, which is why we are rigorous in our analysis. For the last three years our High Yield Bond Fund have benefited from the explicit inclusion of an extra factor in our selection process.

    Investors are becoming increasingly aware of Environmental, Social and Governance (ESG) factors which refer to how a company is governed and its impact on the world around it. This new focus stems from increased corporate monitoring and accountability by the media, politicians and public. A recent high-profile ESG scandal resulted from last year’s BBC investigation into the questionable lending practices of high-street retailer BrightHouse. The rent-to-own company was found to be exploiting the poor and vulnerable by locking them into repayments totalling several times the true value of the goods, making shopping at the weekly payment store more expensive than shopping at Harrods. On the back of this, the Financial Conduct Authority ordered BrightHouse to repay millions of pounds to customers, leaving the company scrambling to refinance its debt.

  3. Reaching a turning point

    ESG has not always been front of mind for investors, and those in different asset classes are at various stages of development in their thinking on the topic. The resolution of ESG related problems can often take a long time so, in terms of long-term equity investing, the firm has always found it essential to consider these risks and potential opportunities in one form or another.

    This has not always been true for bond investing. In fact, until three years ago ESG analysis was not embedded in our process and did not feature explicitly in portfolio decisions. Of course we considered governance in terms of the skills and efficacy of the management team and board of directors, but our decision-making was mostly weighted towards our assessment of a company’s competitive advantage, management and capital structure. 

    Our appreciation of the importance of ESG was enriched following a secondment I took with Baillie Gifford’s Governance and Sustainability team. Baillie Gifford has a long-standing policy of interacting with different parts of the business. The aim is to continually encourage investors to think differently about their portfolios, examine investments from new perspectives, and bring fresh ideas back to their teams.

    For my time there, I applied an ESG lens to one of our then most contentious holdings, Abengoa, in an attempt to aid our decision-making. This is a Spanish engineering and construction company which specialises in building renewable energy infrastructure. At the time, we owned two Abengoa bonds: one convertible and one conventional. The convertible bond had, a few months earlier, outperformed and we reduced our position. The conventional bond, however, was trading at fairly distressed levels. This dichotomy of performance between two bonds issued by the same company speaks to the behavioural challenges of high yield investing.

    Good governance and a focus on sustainability is good for investors and companies through improved business performance and enhanced reputation. As I started my ESG analysis, the first thing I noticed was that there was no diversity in the corporate structure – important because a diverse board will have a broader range of skills, perspectives and experience, to help guide its decision making. This Spanish company had transformed into a globally diversified business and yet, looking closer, this tremendous operational change was not reflected at the management level. All those in leadership were male, Spanish and either related or educated at the same universities. How could this narrow board provide the appropriate checks and manage the inevitable challenges of a global business?

    The next thing that struck me was the series of environmental and social issues, including flooding at one of their businesses in Chile, and water contamination and allegations of bullying of indigenous populations in Mexico. Here was a company supposedly at the forefront of innovation in the renewables industry. It was issuing green bonds and was one of the first companies to enact an internal carbon price, and yet, this behaviour echoed that of a dirty mining company. These issues might not have directly hit its bottom line, but they were red flags to poor governance.

    While I was contemplating these ESG risk markers, we noted that its peers were trading at distressed levels and that Abengoa was adding more and more complex debt structures to fund its operations. Our judgement at the time was that the company’s public commitment to raise new equity would ease the financial pressure it was under. A few months later Abengoa went bankrupt.

    Let me be clear, the bonds did not default because Abengoa abused the environment or engaged in nepotism. An overly stretched balance sheet, short-dated debt structure and discontented shareholders broke the business. The ESG analysis did, however, add to the body of evidence that Abengoa was poorly governed and a riskier credit than we had previously conceived.

     

    Below: Mexican fishermen working in a polluted river.
    © Hector Guerrero/AFP/Getty Images.

  4. AN EVOLVING investment process

    Realising the value that ESG analysis could add in both controlling risk and identifying opportunities for outperformance led to reweighting our factors of analysis. Whereas previously we had focused only on a company’s competitive position, management and capital structure, we realised that the way management interacts with all of its stakeholders including the natural environment communities, was another measure that could alert us to risk. 

    Today governance and sustainability factors are weighted equally with a company’s competitive position and capital structure – three factors that we consider constitute resilience.

    To further our commitment to this enhanced mode of analysis, the High Yield team has dedicated support from an analyst in Baillie Gifford’s Governance and Sustainability team who sits on the High Yield desk once a week, participates in discussions and systematically analyses every holding in order to keep us abreast of material ESG developments. If a holding is flagged up as contentious, the team then decide whether or not to do further analysis as to whether we can justify the holding.

    This additional resource is key since getting our hands on information relating to ESG to analyse can at times be difficult. Roughly half of the companies that are available as bond investments are private – meaning that they do not have to face the same rigorous disclosure of public companies – and the bond team’s influence with management is significantly less than that of an equity investor since we only enter into a contract with a company, rather buying a stake in the business. Fortunately, we are able to draw on the firm’s internal expertise in this area and leverage that strength to our advantage.

    The emphasis of ESG analysis will likely be different from company to company. We may wish for example to focus more on environmental analysis for a mining company whereas regulation may take precedence for a financial company. We are flexible in our approach, not applying a rigid framework across multiple businesses.

    Contentious debates on ESG matters do not preclude investment. If we believed that a company was going to materially improve, or if we were being well-compensated for the risk, we could still hold it, as long as other investment conditions were met. Our improved process is about becoming conscious of the relevant ESG issues, and acting accordingly on that knowledge. Enhanced ESG oversight encourages a deeper, broader discussion, focusing on softer topics, which invariably act as early warnings signals to issues that translate into the numbers, sooner or later.

    The High Yield team has also begun engaging with the UN-supported Principles for Responsible Investment (PRI), an industry body which has been established to help investors understand and apply ESG criteria. To date, the PRI has 1,000 signatories – Baillie Gifford has been one of these signatories for many years. Our Fixed Income approach was evaluated by the PRI for the first time in 2018. We are pleased to score a B ranking, which demonstrates the strength of our ESG process and the positive work we are doing in this area. An important part of this evaluation is the receipt of detailed feedback providing valuable insights into areas for further development alongside the areas where we score highly compared to peers. Our aim is to be best in class, capitalising on Baillie Gifford’s firm-wide Strategy and Governance PRI score of A+. 

  5. Enhanced ESG oversight encourages a deeper, broader discussion, focusing on softer topics, which invariably act as early warnings signals to issues that translate into the numbers, sooner or later.
  6. CONTROLLING RISK

    Another example of how ESG analysis has affected decision-making is the case of Michigan-based sub-prime auto lender, Credit Acceptance, which offers car loans to consumers who are unable to access traditional forms of credit.

    This company has been hugely successful and until recently it was one of the High Yield Bond Fund’s core holdings with an above-average position. However, following a review, the team became aware of recent negative developments concerning business practices, including high dealer churn and vehicle repossession. This was a clear ESG issue and we decided to take a closer look. 

    Thanks to a pre-existing good relationship with Credit Acceptance, the treasurer of the firm was willing to speak honestly. He admitted the company was aware of the negative perceptions, but shared some impressive statistics on the loan repayments – 87% of collections are scheduled payments from customers – and on how it interacts with dealers. He explained that the reason it lost 30% of dealers each year was, in part, out of choice: Credit Acceptance would cut ties with aggressive dealers to keep its customers and bottom line safe.   

    Admittedly it is easy to tarnish the reputation of a sub-prime lending business. There is an ongoing debate as to the morality of lending at high rates of interest to people who are already economically disadvantaged. On the one hand Credit Acceptance provides legitimate, regulated credit when others do not and may help customers build their credit history. On the other, the costs of providing this credit make it an expensive option for customers.

    As investors, we do not feel it is appropriate for us to make difficult moral decisions on behalf of our clients, but we do need to be confident that a company not only complies with laws and regulations but also has good oversight and independent challenge from the board. While our discussion with Credit Acceptance’s treasurer eased our concerns about customer exploitation, it brought another risk to light.

    This is a company with an extremely small board – just four people – with an average tenure of more than 15 years. With the chairman and chief operating officer both recently departed, and no replacements identified for either, our concern increased about the level of challenge within the business.

    While our conversation had reassured us that the current business practices were legitimate, the lack of independent challenge from the board risks amplifying any missteps by management.

    With this is mind, we took the decision to sell out of our holding, and reduce our exposure to a risk that we may not have been fully aware of prior to enhancing ESG in our risk analysis. 

  7. IDENTIFYING OPPORTUNITIES

    The High Yield team believes that not only does ESG analysis provide a further layer of risk management in the existing portfolio, it can also help discover new investment opportunities.

    A case in point is the US-based, global giant Darling Ingredients which transforms animal by-products into a diverse array of useful end products. It predominantly makes animal feed and pet food, but also creates bone china, gelatin, collagen, blood thinners, proteins, and its most recent innovation is the ability to transform animal fats into biodiesel.

    When we began to analyse this company from an environmental perspective, we recognised that the company had a substantial competitive edge. Because Darling deals daily with pathogen-rich raw materials, it has to comply with a vast number of regulatory bodies across environmental health, occupational health and product safety, all around the world. Thanks to its scale and financial fire power, Darling has the ability to invest in the compliance required to be the safest, healthiest and most sustainable business in that space, giving it a competitive edge and also acting as a barrier to entry for others wanting to compete in this sector.

    On the governance side, the team also saw that there was a good mix of experience on the board and a level of independence in decision-making. The outcome: a decision to buy. Darling Ingredients has since seen positive growth and we think it could possibly be upgraded to investment grade.

  8. Summary

    ESG issues have long influenced Baillie Gifford’s thinking on equity investments. It is something, as a firm, that adds to our competitive edge and our reputation as responsible stewards of capital.

    In the past three years, the High Yield team has begun to see the benefits of analysing ESG issues to both manage risk and source new opportunities, and is able to draw on Baillie Gifford’s considerable in-house expertise in this regard. We believe that weighting governance and sustainability equally with the durability of a company’s competitive position and the sustainability of its capital structure helps us to identify resilient businesses that should provide our clients with attractive returns.

  9. Important Information and Risk Factors

    The views expressed in this article are those of Lucy Isles and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

    This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

    This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

    Investment markets can go down as well as up and market conditions can change rapidly. The value of an investment in the fund, and any income from it, can fall as well as rise and investors may not get back the amount invested.

    Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the fund invests may not be able to pay the bond income as promised or could fail to repay the capital amount.

    The fund’s concentrated portfolio relative to similar funds may result in large movements in the share price in the short term.

    This information has been issued and approved by Baillie Gifford & Co Limited. Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority. Baillie Gifford & Co Limited is a unit trust management company and the OEICs’ Authorised Corporate Director.

    All information is sourced from Baillie Gifford & Co Limited and is current unless otherwise stated.

    The images used in this article are for illustrative purposes only.

     

    Annual Past Performance to 30 June each year (%)

      2015 2016 2017 2018 2019
    Baillie Gifford High Yield Bond Fund -0.7 0.9 12.6 1.7 6.7


    Source: FE. Class B accumulation shares. Returns reflect the annual charges but exclude any initial charge paid.

    Past performance is not a guide to future returns.

     

    Ref: 41911 IND WE 1103

  10. LUCY ISLES

    Joint manager of the Baillie Gifford High Yield Bond Fund

    Lucy joined Baillie Gifford in 2012 and is co-manager of the High Yield Bond Fund. Lucy graduated MA (Hons) in International Relations and Modern History from the University of St Andrews in 2011.