Poor PreferencESG

Preference shares took centre stage on the financial pages and Aviva press cuttings during March. It looks like we haven’t seen the end of the shenanigans with reports of further FCA digging. So what was all the fuss about?

Firstly, a bit of relevant background. These preference shares look like a bond (pay coupons) but have no fixed maturity i.e. are irredeemable. They also look like equity, carrying voting rights. Issued back in the early 1990s, at the time they added to the capital of the issuer and have traded like ultra-long bonds. Indeed as the instruments were issued with dividends (coupons) in the ball park of 8%, it is no surprise they have traded materially above their 100 issue price. The Aviva 8.625% bond was trading at 175 before the Aviva announcement.

So why did Aviva make its proposal to cancel these preference shares? Since the financial crisis there have been myriad changes to banking regulation and one of the outcomes of this is that these preference shares are not as useful as they were in counting towards capital as set down by regulators. Thus, Aviva, not unreasonably, sought to figure out how it could redeem the irredeemable preference shares.

Nothing wrong so far except for the plan. The plan proposed was in essence to amalgamate the voting rights of ordinary shareholders with those of the preference shareholders, ensuring the preference shareholder voice was drowned. Or put another way: propose a legal scheme by which the small minority (the preference shares) who are receiving those 8.625% coupons are made to vote equally with the vast majority of shareholders, who are in essence paying the 8.625% coupons. Good for ordinary shareholders because the proposition was to buy the preference shares back at 100 – where they were issued over 20 years ago – rather than the current market price of 175.

Even more succinctly, the scheme proposed a compulsory property purchase at 1990s prices (100) rather than today’s price (175). How could that “clever” scheme have been proposed? Who thought that that could be a good idea for ALL stakeholders? Forced appropriation of assets at below market price isn’t the stuff of equitable governance. No wonder there was uproar; the proposal had all the hallmarks of inward looking self-interest and absence of broader scrutiny.

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Why ESG is not new to EMD

At Kames our approach to emerging market debt shares some of the underpinnings of ESG investing. Moreover, this focus has always been integral to investing in emerging markets, long before its strands became as widespread as they are today in developed markets investing. In emerging markets, numbers have always been only half the story. Below are some thoughts and examples of what else counts.

The most important ESG factor in emerging market debt is governance. At both the sovereign and corporate level, bad governance in emerging markets can impair an investment well beyond the level typically possible in developed markets. Simply enough, the backstop of the rule of law, relied upon by investors in developed markets, is much less tested in emerging geographies. This means that the quality of the people (whether government ministers or management teams) and organisations (Ministries of Finance, Central Banks, and the like) involved is vital.

A good example at the sovereign level are the two West African countries Senegal and Cote d’Ivoire. Both score well on the highly-regarded Ibrahim Index of African Governance. Both are members of WAEMU, the West African Economic and Monetary Union, with its emphasis on co-operation, stability, and its ties to France. In addition, Senegal arguably has a stronger democratic tradition than many of its regional peers. Such indicators of governance strength are critical pillars of the credit cases in these names.

On the negative side, our view of Russian private banks and corporates is consistently held back by the encroachments of the state on the business interests of independent actors there. Notwithstanding the fact that there are, and have been, some high quality, non-state owned banks and corporates in Russia, it is hard to see past the Russian government’s centralising instinct, and its controversial foreign policy decisions, which have rebounded heavily on the Russian economy in the form of sanctions. These factors act as a persistent drag on the investment case for Russian debt.

As emerging market debt is often driven by, or linked to, commodities – oil & gas, metals & mining, agricultural commodities, and the like – and as the production of these very often has a lasting impact on geographies and populations, the questions of environmental and social factors should not be ignored, either.

For example, investors in credits exposed to Nigerian oil and gas should be aware of the controversial history of foreign involvement in the Nigerian energy space. Whether it is the industry’s environmental impact, its record in employing locals, or the imperfect nature of contracts signed, the sector is steeped in environmental and social challenges that, from our perspective, significantly raise the bar for investment in it.

More constructively, it can be argued that a positive example of social change is currently to be seen in Saudi Arabia. Under the new Crown Prince, steps are being taken to ease restrictions on the country’s large young population. These include the easing of segregation between sexes, investment in entertainment venues and the marginalisation of the religious police. There is no doubt that Saudi Arabia faces multiple challenges of other sorts under Mohammad bin Salman – a still heavily oil-dependent economy, an aggressive foreign policy, among others – but the steps being taken undoubtedly strengthen the investment case for Saudi Arabia.

It is very important to stress that questions of governance, as well as social and environmental challenges, are far from black and white issues in emerging markets. Politics are imperfect; social norms vary widely; economies are resource heavy. Indeed, an attempt to enforce a ‘one size fits all’ approach to these matters in emerging markets would be both ill-informed, and a mistake. That said, at Kames we closely consider these factors when buying emerging market bonds. In emerging markets, numbers have always been only half the story.

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Watering down tax structures

On 28 July 2010, the United Nations General Assembly explicitly recognised the human right to water and sanitation. It will also come as no surprise that in the UK we have enjoyed clean water for generations. Investing and supporting companies that deliver clean water certainly falls into ESG investing.

However, ownership of the assets that deliver water and sanitation has become political in the UK. As investors in bonds issued by water companies, we are keen to ensure that we maintain the value of our investments. There are three strands to our analysis. First is the effective management of these companies. Second, is the ability to reinvest in assets to deliver future cash flow and returns. Finally, exploring the social, regulatory and political environment in which companies operate.

It is this very last point that has recently become more material in our assessment of the UK water companies. At the start of February the Social Market Foundation issued a report claiming that the nationalisation of the water industry would cost in excess of £90bn. Water and its ownership have become a political issue; the election campaign in 2017 saw the Daily Mirror run this headline: “The Labour Party claims the water industry has been used for tax avoidance and says it’s time to bring it back into public ownership”. The use of offshore tax structures have become a political issue for an industry that has spent, and needs to spend, billions investing and delivering water in the UK.

Our fixed income team, together with our ESG-research team, has penned a letter to a number of major bond issuers in the UK water sector. We wrote that the nature of delivering clean water infrastructure requires further investment but that past and future investment should be conducted in a tax framework that, in itself, gives confidence to the public as consumers. There was no accusation of tax evasion but that certain efficient tax structures are not publically acceptable in times of strained public finances. We wrote that “Perceptions of what is acceptable have undoubtedly changed in recent years” and encouraged issuers to review tax structures that offer the perception of “cute” financing arrangements.

As investors our responsibility remains to the value of our investments. As such, and as our letter stated, “It is our responsibility to balance any reputational issues that adverse publicity may create within our overall risk assessment”. The rights and merits of public or private ownership are not ours to judge, but where we can influence to reduce uncertainty and volatility in the value of our assets, that is in our gift and interest.

Transparency builds trust and goodwill with all stakeholders (including investors). We hope that in some small part we can encourage transparency in how the companies we invest in manage their arrangements and in doing so, ensure effective delivery of water to all in the UK.

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G stands for Governance not Green

The explosion in demand for green bonds in recent years has left them looking expensive versus other fixed income securities, with better options available to investors outside this niche part of the market.

Over $100bn of green bonds have been issued so far this year, with the euro-denominated market leading the way after accounting for 43% of all issuance. Investors have been attracted in their droves to green bonds, with market conditions exceptionally favourable for the securities over the past 18 months.

As a result, issuers have generally been able to dictate the terms of new debt and thus rush to create green bond structures. The sector has become overvalued as a result.

We do not want to ruin the party, but we choose to avoid buying green bonds due to current pricing. Where an issuer’s long-term ability to pay is not backed up by the right business model or balance sheet, adding a green moniker to that issuer will not make us invest.

Investors must consider green bonds within the wider context of ESG, and ensure they drill down into the underlying drivers for each bond, rather than focus simply on the notion that they have some level of green credentials. In particular, investors need to be aware that the underlying risk from green bonds is not ring-fenced from other debt the company may have issued.

Our belief is that green bonds should be treated much like any other anomalies; we will seek to exploit them. Where we can lend to an issuer for the same length of time, with the same security, and support a green project – that is great. But we are not in the business of lending money to the disadvantage of our portfolios and clients where the cash raised by those issuers is fungible with the rest of their cash pile and our security is ranked along with all their other debt in the issuer’s general corporate purposes.

Green investing should be actively encouraged, but not at prices or in companies that could otherwise not pass investment scrutiny. A strong business model and good governance are key to our process and ESG success. That ‘G’ stands for Governance, not Green.

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A green opportunity, but at what cost?

Green bonds have grown in prominence over the last couple of years, with a company’s ESG (Environmental, Social and Governance) credentials assuming ever-greater importance for investors. The terminology used to describe green, or ethical, bonds – and the definition of investing ethically – can often be interchanged to such a degree that the end investor is left with an incorrect understanding of the difference, and perhaps a lack of appreciation of the risks.

Dedicated green or ethical bonds are sometimes issued by established blue-chip corporates (e.g. Lloyds and SSE have issued green bonds in recent times); the proceeds of such issuance is essentially ring-fenced by the issuer to fund socially responsible or environmentally-friendly projects. Liquidity in instruments issued by such well-established entities is typically as deep as would be the case with the rest of such an issuer’s capital structure.

Unfortunately the same liquidity is rarely as prevalent in green bonds issued by unlisted entities, regardless of how “green” the opportunity may be. The substandard issue size of such bonds (very often less than £100m outstanding), combined with the lack of disclosure limits the scope that such bonds can be bought or sold in the secondary market. It is this trade-off between maintaining liquidity in an investor’s portfolio, whilst maintaining their overarching desire to fund responsible and environmentally-friendly businesses that perhaps deserves greater attention than it is given.

One avenue that facilitates an efficient combination of the dual requirements of investing ethically without compromising liquidity is to invest in an ethical fund. At Kames we have managed ethical portfolios since 1989, with an independently administered “dark green” screen in place to ensure that the portfolio’s investments are consistent with the expectations of our client base. The end investor has regular disclosure on the nature of the fund’s exposures, whilst they can also sleep well in the knowledge that their investments have daily liquidity.

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The Future will be green, or not at all

Before President Trump began a period of mutual sabre rattling with North Korea, he made arguably his biggest decision so far as President in withdrawing the US from the Paris climate agreement.

The withdrawal of the most powerful country in the world failed to derail the other members of the G20 from their commitments, they were unwavering. Even in the States they are likely to meet their targets on emissions in spite of the President.  The move towards environmentally friendly policies feels inexorable.

It is perhaps no surprise then that issuance of green bonds is increasing (up 56% in the first half of the year) matching a growing desire among companies and investors alike to fund projects which will aid the fulfilment of the aforementioned Paris agreement.

Recently, we saw a green bond issuance from Anglian Water, the company already having several climate aligned bonds as estimated by HSBC. These are issues which are used to finance low carbon and climate resilient infrastructure. This was their first issue which could be officially labelled as green, being assessed for its eligibility by the company DNV GL.

Anglian have a practical interest in supporting action against climate change. The company operate in the British region most prone to weather related water shortages, which is likely to be exacerbated as population under their coverage is forecast to increase by one million over the next 25 years. As the company noted, environmentally friendly projects are efficient and cost effective, and in a sector that rewards efficiency (through terms set by the regulator Ofwat), this is a consideration of vital importance.

The Anglian Water green bond issue fulfilled Kames screening criteria for our ethical funds, and was added selectively throughout our fund range.

Trump may disagree, but the signs are that “the future will be green, or not at all” (Jonathon Porritt).

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Valuations Sour the Green Apple

This week saw the issuance of Apple’s second green bond, a $1billion 10-year transaction to help fund its goal of running 100% of the company’s operations on renewable energy. The issue builds on $1.5billion of green bonds sold by Apple a year ago, the biggest ever green bond issued by a US corporation. Whilst Apple has plenty of cash on its balance sheet the company’s issuance has helped fuel a surge in dollar green bond issuance last year, with 2016’s supply doubling 2015’s total issuance. This year so far, around $120billion worth of green bonds have been issued by corporations.

Apple has an agenda, epitomised by CEO Tim Cook attempting to persuade Donald Trump not to leave the Paris Climate Accord. Apple is committed to making the future iPhone solely from recycled materials but currently only a small percentage of the current iPhone is made from them. Apple has identified a number of materials used in their products which can be recycled and used in new products, for example aluminium that is used in the current iPhone 6 can be melted down and used in Mac computer cases.

December 2016 also saw Apple investing in four subsidiaries of China’s largest wind turbine manufacturer, Goldwind, taking 30% stakes. They are targeting directing power from the wind turbines to Apple manufacturers based in China. The company is currently using renewable energy in 96% of their stores and factories with the goal of increasing this to 100%. Apple scores very well in the E component of our ESG scoring but controversies still lie around their supply chain management, use of child labour and hazardous chemicals usage.

For investors the new green bond was fully priced at +82bps spread over the US Treasuries curve. Initial price talk at +95-100bps would have offered investors some value at launch but final pricing left little to excite. In the basket of Apple bonds this wasn’t necessarily the one to pick and, whilst the ‘green’ label is to be applauded, for a company the size of Apple corporate responsibility is more material than the odd billion of green bonds.