ABS framework the next frontier in ESG

Hermes report says asset backed securities need a more rigorous framework

A more rigorous framework for applying ESG factors to asset-backed securities (ABS) is the “next step for investors” to push the industry forward, according to a report by Hermes Investment Management.

In its latest Spectrum report, the asset manager found that while ESG integration has hit the mainstream across multiple asset classes, focus on ESG factors in ABS has been more limited.

According to the report, while incorporating ESG within ABS would far from require a complete rethink of the sector, there are challenges that are unique to the asset class.

“Investors are analysing structures that hold pools of collateral – the underwriting, origination and servicing of those assets is key to the performance of the ABS securities. The structure of the securitisation vehicles also needs to be reviewed to ensure it will support the performance of the assets and aligns noteholders interests,” the report states.

To improve the assessment of ESG factors across ABS, a more standardised framework would be required to enable traditionally non-financial factors to be incorporated into wider credit analysis, the report’s author and Hermes’ ABS Portfolio manager Andrew Lennox said.

“While the issue of a lack of data may deter investors from really tackling ESG factors in ABS, the framework by which investors can assess a broader set of environmental, social and governance risks to ABS warrants further consideration.

While the ‘E’ factor in ABS is evident in energy-efficient mortgages and the financing of alternative fuel autos, it is not so obvious how social and governance factors can be applied to ABS transactions and structures.

However, Lennox said there are a number of ways to factor these in.

“Many of the elements that already form a part of the credit analysis of ABS deals can incorporate ESG factors, even where issuers and investors have not yet necessarily highlighted them as specifically ESG-related. ESG factors can be assessed when analysing the underlying assets backing securitisations, how those assets are serviced as well as the structures themselves,” Lennox said.

For example, when looking at the social aspect of securitisation, the vast majority of securitisation is backed by assets that are financing the “real economy” – products to help ordinary consumers finance their everyday lives.

“To consider social factors that investors can use in a meaningful way, it is necessary to differentiate between the originators and the individual credit merits of individual transactions. As investors, it is our responsibility to analyse the arrears, the collection, the debt management and the forbearance policies of those lenders as well as the recovery processes they use,” the report explained.

However, based on current data it is difficult to conclude whether ABS and residential mortgage-backed securities (RMBS) with strong environmental credentials perform better than those with less of a green focus, according to the report.

For one, there is little evidence to suggest that borrowers with energy-efficient properties are less likely to go delinquent and default on their mortgages, the report states, although lower energy bills will improve a borrower’s affordability metrics, while the values of energy-efficient homes could outperform less efficient properties – especially if the regulatory and political tides move to discourage energy-inefficient housing.

“Until enough data becomes available which clearly demonstrates that these borrowers have a lower risk profile over housing market cycles, lenders are likely to be slow to incentivise green property improvements through lower rates, rating agencies will be unable to re-calibrate their models for energy-efficient lending, and investors are unlikely to accept lower yields as a result,” the Hermes report warns.