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Portfolio managers Brent Olson and Tim Winstone, explore the high yield asset class and demonstrate how its heavier exposure to industrials need not hold it back from decarbonisation.
Take a snapshot of the global investment grade corporate bond market and the global high yield corporate bond market and chances are that the high yield bond sector will have a higher weighting to industrials. As Figure 1 shows that rings true today.
Figure 1: Sector weights within global high yield and investment grade corporate bond universe
There is some logic to this. First, the high yield market tends to be more exposed to cyclical sectors where greater variability in earnings often leads to credit rating agencies giving a sub-investment grade rating to the company. Second, companies needing to raise finance for big projects tend to take on more leverage, which is again something that can lead to a lower credit rating. Third, companies raising capital for the first time or for new or exploratory projects such as mines or oil fields will often find that they are rated high yield until their operations are more proven.
Today, the industrial sector makes up approximately 85% of the global high yield corporate bond market compared with 55% of investment grade corporates (as at 31 May 2023). Moreover, energy, basic industry, capital goods, automotive and transportation – which comprise some of the most carbon-intensive sub-sectors such as oil and gas, mining, machinery, packaging, and air transportation – constitute around 35% of the high yield universe.1
Unless a fund has blanket exclusions for specific areas, it is difficult to avoid carbon-intensive borrowers in high yield without heavily narrowing the investment universe. Moreover, many of these companies provide products and services that are either necessary for the global economy to function or will be required through the transition to a low-carbon economy.
In our opinion, a pragmatic approach is to recognise that many of these companies operate in hard-to-abate sectors. Rather than avoiding them we focus on (a) encouraging them to do better through engagement and (b) allocating capital to those that are best managing environmental, social and governance (ESG) risks and opportunities – these companies are best positioned to succeed in the future. It is this practical, research-based and forward-looking approach that treats ESG factors in the same way we do any other fundamental, financially material factor that we believe can help us to identify good credits.
An example of a company whose bonds we hold and that is making considerable efforts to decarbonise is Fortescue Metals Group (FMG). Its decarbonisation efforts are reflected in our ‘Yellow’ proprietary ESG rating. FMG is a mining company that extracts iron ore. S&P Global Ratings gives the company a credit issuer rating of BB+, while Moody’s similarly applies Ba1, at the top-end of the sub-investment grade credit rating scale.2 While mining is an industry that scores poorly overall from an ESG perspective, we view this company as making demonstrable efforts to address its environmental impact.
Specifically, FMG’s strategy is to transition to a global green energy and metals company. To meet this objective, it has undertaken a strategic review of its entire power plant operations (through investment in renewables, energy storage and transmission, it is seeking to displace the diesel and gas-fired power generation at its mines). Executive long-term incentive plans are linked to emission reduction targets, including carbon neutrality across its operations (net zero Scope 1 and 2 emissions) by 2030. The company has committed to Science Based Targets Initiative (SBTi) emissions targets (to be approved). It is shifting its haulage fleet towards zero emissions vehicles with Liebherr and is developing the world’s first ‘infinity train’ that will capture enough energy on the loaded downhill journey not to require additional charging for the return trip.
It has also created a subsidiary, Fortescue Future Industries (FFI), which is working on developing technologies to help decarbonise and is building a portfolio of green hydrogen and green ammonia projects. The company’s initiatives make economic sense and should allow it to achieve operating cost savings through the elimination of diesel, natural gas, and carbon offset purchases from its supply chain. Furthermore, they should make FMG more resilient to climate transition risks (regulatory, legal and reputational), which ought to reduce medium-to-long term credit risk.
Over the period of (largely) 2024-2028, FMG expects to invest about US$6.2bn split across different initiatives as shown in Figure 2.
Figure 2: Capital investment breakdown by type
Like mining, the oil sector is a high carbon emitter. The war in Ukraine refocused interest on the oil and gas industry as countries increasingly seek to balance sustainability, affordability and energy security (the energy ‘trilemma’ as it is often known). To give an example from the oil and gas industry, an oil company whose bonds we held in some of our high yield portfolios until recently was Occidental Petroleum (Oxy). Its credit fundamentals were improving, with high oil prices allowing it to pay off around a third of its outstanding debt in 2022.3
As part of our engagement work with the issuers in high ESG risk sectors, we engaged with Oxy in March 2023 regarding its initiatives to decarbonise, with a focus on Direct Air Capture (DAC). This removes C02 from the air and converts it to a liquid to be sequestered (stored away) or used as a feedstock. The economics of DAC are driven by carbon credit buyers and its first plant is set to start in 2025, offering a potentially new source of revenues for the company. Overall, whereas this project alone is not sufficient to change Oxy’s ESG risk profile (our proprietary ESG rating for the company is ‘Red’, signifying material ESG risks), we will continue to monitor the company’s progress in using innovation to aid its decarbonisation initiatives and we will conduct ongoing engagements with the company.
The company is rated sub-investment grade by S&P, but investment grade by Moody’s.4 On 16 May 2023, Fitch upgraded its rating on the company to BBB-, the effect of which was to propel Oxy up into investment grade from high yield in most indices from 1 June 2023. The upgrade was not insignificant as it removed US$15bn of bonds from the ICE BofA US High Yield Index, leaving the energy sector within US high yield at its lowest percentage weight (10.1%) since 2008.5 Its bonds have also exited the ICE BofA Global High Yield Index. As much of the credit improvement was now priced in and to avoid holding too much investment grade within a high yield mandate, we sold our holding in Occidental Petroleum.
Taken together, we see these as representative examples of how companies in hard-to-abate sectors such as mining and oil and gas are rising to the challenge of decarbonisation. Change is happening from within as companies respond to stricter environmental legislation and shifting consumer opinion. As suppliers of debt (and equity) capital, we can also lend our voice to change that makes sense from both a long-term credit and ESG perspective. The latter needs to be looked at thoughtfully and to recognise that decarbonisation in higher-emitting industries is a long-term journey. Through our active engagement with companies, we seek to ensure we have a thorough understanding of how companies are managing climate mitigation and to play an important role as credit investors in the ultimate success of companies in this crucial transition.
1Source: Bloomberg, sector weights for high yield relate to ICE BofA Global High Yield Index and for investment grade ICE BofA Global Corporate Index, as at 31 May 2023
2Source: Refinitiv Eikon, ratings correct as at 20 June 2023.
3Source: Oxy 2022 Annual Report, page 48. Oxy repaid US$10.5 billion, reducing the face value of its debt to less than US$18 billion by 31 December 2022.
4Source: Refinitiv Eikon, ratings correct as at 20 June 2023.
5Source; Morgan Stanley, Energy Credit Research, 22 May 2023.
References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.