Andrew Lennox, senior portfolio manager at the international business of Federated Hermes, answers SCI's questions

Q: How and when did the international business of Federated Hermes become involved in the securitisation market?
A: The Federated Hermes European structured credit team consists of senior portfolio manager Stephane Michel, me and two analysts covering the universe of ABS and CLOs. I arrived at the firm 2.5 years ago.

One of the attractions of moving to work at Federated Hermes was its strong track record in ESG, having been at the forefront of sustainable investing for over 30 years. I had a blank canvas with which to begin building a framework and philosophy for structured credit at the firm; that was specific to structured credit but leveraging the firm’s existing internal ESG resources.

The structured credit market has lagged the progress made in other sectors in terms of adopting ESG principles. Beyond looking at the explicit environmental elements of green ABS, for instance, there has been little emphasis on assessing the social and governance factors within securitisation. We’re looking to move this forward and make real progress at Federated Hermes.

Q: What are the firm’s key areas of focus today?
A: To consider ESG factors in connection with securitisations does not require a total rethink of how to perform credit analysis; rather, the analysis should be viewed through an ESG lens. ESG is core to how we analyse structured credit and its performance.

We score everything we invest in from an environmental, social and governance perspective to come up with a weighted average score that we use to differentiate between deals. Not only can we draw out ESG factors when analysing the underlying assets backing securitisations, we can also consider ESG factors when analysing how those assets are serviced as well as the structures themselves. For example, from a governance perspective, investors in securitisation structures should assess whether servicers are being paid appropriately, as well as the risk mitigants and noteholder protections in a deal.

It’s not enough to recognise that lending to consumers has a social aspect to it: the quality of that lending also has to be considered. This is where social and governance factors start to interconnect – good governance in origination and underwriting practices can support social factors as well. As such, the sustainability of the lending – assessing whether borrowers can afford to pay, including in stressed scenarios – needs to be analysed too.

Over time, performance data will show whether a lender provides financing on a sustainable basis. High delinquencies and defaults could suggest a lender has been underwriting unsuitable products, financing borrowers with unsuitable creditworthiness, or both.

As an investor, it is our responsibility to analyse the arrears, collection, debt management and forbearance policies of lenders. There is a social imperative to allow a borrower to remain in their home, for example, even when they have ceased to service the debt. Nevertheless, this also has to be balanced against what is financially prudent.

From our perspective, the governance weighting has come to the fore this year, given the current environment and widespread Covid-induced payment holidays.

Q: How does the firm differentiate itself from its competitors?
A: Marrying an ESG framework with sound credit analysis results in strong investment processes. If an investment scores highly from an ESG perspective, it is likely to score highly from a credit perspective too.

Q: Which challenges/opportunities for you anticipate in the future?
A: To further the adoption of ESG principles across the securitisation market, better data collection is required, as well as quantifiable proof that deals with higher ESG scores lead to improved financial performance. In turn, this will not only encourage the expansion of ESG products, but also ESG investing in the asset class.

The industry is aware that more needs to be done and there are significant differences between one lender and another in terms of ESG adoption. Some adhere to ESG policies; some take energy efficiency into account in their lending processes; some release sustainability reports; and others don’t pursue any of these activities.

As an investment house, we’re pushing for more ESG disclosure across the board. We’re working with a group of lenders under the auspices of our EOS stewardship team. With £1.1trn assets under advisory, as at end-June, the idea is to act as an engagement platform that leverages the team’s expertise to encourage sustainable lending practices for the long term.

More broadly, the bond market needs to tackle the issue of greenwashing. One advantage of securitisation is that the collateral in an SPV can define whether the bonds can definitively be classified as ‘green’ or ‘not green’; in other words, it is clear that a securitisation is truly ‘green’ because the use of proceeds is clear. Consequently, the industry has the perfect opportunity to finance green or socially beneficial projects.

Corinne Smith