The COVID-19 pandemic is a devastating global crisis with paradigm-shifting implications for society, the economy, and corporate governance. As ESG-focused bond investors, we believe the crisis presents us with an opportunity to evaluate the long-term resiliency of corporate bond issuers and how well management priorities are aligned with strong ESG risk management practices.
Learning from COVID-19
One consequence of the COVID-19 crisis may be that the market will take future tail risks more seriously than in the past. As the world adjusts to the economic realities of pandemic mitigation, market participants won’t soon forget the profound dislocations that we saw in March, which rivaled, and in some ways surpassed, those experienced during the 2008 global financial crisis (GFC). In the post-pandemic environment, we believe companies with characteristics such as a clearly defined purpose and a strong balance sheet that’s managed with shareholders and a broader set of stakeholders in mind—including employees and the communities in which their operations are embedded—are more likely to be sound, long-term investments.
The United States experienced 21 recessions in the twentieth century, and there’s evidence that corporate governance lapses were more prevalent during these periods.¹ In our view, the honesty, quality, and integrity of management are crucial in such times; when it was lacking, bondholder losses frequently ensued.² From our perspective as financial analysts, we believe that material ESG data can offer a clear-eyed view of management quality.
ESG research implications during and after the crisis
With the plunge in economic activity brought on by today’s crisis, we've focused much of our attention on assessing the consequences of a marketplace with significantly weakened demand. This has involved stress testing and evaluating the liquidity profile, capital structure, and free cash flow capabilities of companies under coverage. We believe that a keen focus on financial strength in times of stress can position a well-managed company for long-term capital investment that sustains operations, market positioning, and stakeholder well-being.
We continue to evaluate how company leadership is responding to the unprecedented financial and operational challenges brought on by the crisis. We’re particularly interested in how these responses can illuminate potential environmental, social, and governance (ESG) risks and, ultimately, affect credit quality. As part of that effort, we’ve been using company engagement discussions to inquire about how the crisis might affect a company’s ESG profile, including details about the potential impact on employees, a company’s board and governance structures, and its supply chain. These issuer engagements factor into our current and long-term views on specific credits.
Just as the GFC revealed lapses in bank risk management, an overreliance on risk models, and a lack of sufficient financial acumen at the board level,³ we believe this crisis is revealing a new dimension for ESG research. The importance of management decisions affecting employees, customers, and communities has been highlighted by conditions dictated by the virus. In some cases, these decisions revealed preparedness and resiliency, while in others, the opposite has been true. We’re especially mindful of cases in which human capital decisions suggest long-term implications for issuers’ productivity and financial performance.
Pandemic to put a spotlight on intangibles
Intangible assets, including intellectual property, patents, trademarks, goodwill, and brand value for S&P 500 Index companies, were valued at just over $20 trillion in 2018.⁴ That said, intangibles are challenging to value and subject to annual impairment tests. But in times of crisis, intangible asset value can experience immense pressure, and clear-eyed assessments of risk can force an intangible value reckoning.
Brand equity and customer relationships are two areas of relevant concern. In the months ahead, markets will seek to judge whether companies have dealt—and continue to deal—thoughtfully with the problematics presented by COVID-19, particularly around questions of customer treatment and, depending on the industry and business model, efforts to provide aid and pandemic-related solutions. These management-sanctioned decisions may go a long way toward defining future brand equity and the health of customer relationships. Management teams that hurt brand value through their actions in this crisis and/or those that may have overpaid for assets during the preceding merger boom could be at high risk for future asset value write-downs.
Long term, ESG analysis remains critical
In our research, we seek to invest in companies with management teams that understand that benign operating environments don’t last forever. Their plans should 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.
Breckinridge Capital Advisors initiated its ESG research as part of our credit risk analysis almost a decade ago. Today, we integrate ESG research across our investment strategies and offer clients a range of sustainable approaches that emphasize ESG factor analysis. We believe that this fundamentally research-driven sustainability lens is part of the edge offered by our approach to credit risk and that it will help us continue to build resilient bond portfolios for our clients in the future.
1 "White-Collar Crime and Economic Recession," University of Chicago Legal Forum, 2010. 2 “What Led to Enron, WorldCom and the Like?” Stanford Business School, October 2003. 3 "The Corporate Governance Lessons from the Financial Crisis," Financial Market Trends, OECD 2009. 4 "Intangible Assets: A Hidden but Crucial Driver of Company Value," visualcapitalist.com, February 2020.