Introduction

MacKay Shields High Yield team employs a research intensive, bottom-up, value oriented approach to investing in the high yield market. Central to our approach is in depth security specific research to identify attractive investment opportunities and associated risk factors unique to any particular investment or to the portfolio in aggregate. Risk factors can come in a variety of ways and may take many forms. They could include, among other things, technological change, demand/supply characteristics, company positioning, undue leverage, regulatory issues as well as ESG related factors. Each of these and other risk factors, along with an analysis of probabilities and margins-of-safety, are incorporated into the research and decision making processes to understand the long term value of a company.

Our purpose in this policy is to outline the approach which will be used by the MacKay Shields High Yield Team to address ESG specific risk factors in the investment process.

(i) Bring greater transparency to the manner in which the team incorporates ESG specific factors into the research and investment processes used in the construction of high yield portfolios; and

(ii) Where requested by clients, place a greater weight on ESG factors in security selection and overall portfolio construction.

 

High Yield Group Investment Process

MacKay Shields’ High Yield Group’s strategy is a bottom-up, value-oriented approach to investing in the high yield market. Our objective is to outperform the high yield market over the long term through superior credit selection, while mitigating downside risks. Our approach to this objective involves maximizing the default adjusted yield and spread of a diversified portfolio. The key feature of our strategy is our disciplined investment process that we have employed since 1991.

 

Given the asymmetric risk/return profile of investing in high yield bonds, we believe superior credit selection, appropriate risk compensation, and a focus on downside protection are required to invest successfully in the high yield market. As a result, the most important part of our investment process is "margin-of-safety" analysis. Every high yield security we invest in must have a large margin-of-safety through asset coverage and free cash flow. We define asset coverage as the ratio of our estimate of a company’s value to the amount of its debt (the inverse of asset coverage is loan-to-value). Every high yield security we invest in must have a minimum of 1.5x asset coverage. We believe this builds in a significant margin-of-safety and downside protection. Every credit must also have free cash flow, which we define as cash that a company is able to generate to pay down its debt.

We ultimately focus on approximately 300 issuers that pass our margin-of-safety analysis and also have a catalyst for total return.

We then categorize every security in our portfolios into one of four Risk Groups that are delineated by the strength of the asset coverage and the potential for default as described in the table below:

 

Our goal is to maximize the default-adjusted spread of a diversified portfolio, which depends on the market environment. During periods in which we view default-adjusted yields and spreads as unattractive for credit risk, our portfolios will be more heavily weighted toward higher quality Group 1 credits and we will have less exposure to riskier Group 3 credits. During periods in which we view default-adjusted yields and spreads for riskier credits as attractive, our portfolios will increase exposure to Group 3 credits while reducing exposure to Group 1 credits.

Our default-adjusted approach keeps us disciplined regardless of the market environment. It prevents us from purchasing riskier credits in frothy markets where spreads are unattractive and keeps us focused on the long-term value of a bond in periods of market weakness.

 

ESG Risk Groups

In addition to these risk groups, we will also formally categorize the securities that meet our investment process into four groups based on the assessed ESG risks associated with each security. Typical characteristics of ESG risk group classifications are as follows:

ESG RISK
 

ENVIRONMENTAL

  • Climate Change
  • Sustainability 
  • Pollution & Waste

ESG Risk Group 1
Low Risk

No material environmental liabilities and capacity to reduce climate footprint.

Low risk of increased regulatory scrutiny and proposed legislation.

Long-term commitment to sustainable practices.

Full compliance with local standards and regulations.

ESG Risk Group 2
Low Material Risk

May have some environmental liabilities.

Some risk of increased regulatory scrutiny and proposed legislation.

Commitment to sustainable practices.

Full compliance with local standards and regulations.

ESG Risk Group 3
Material Risk

Material environmental liabilities.

Some potential for increased regulatory scrutiny and proposed legislation.

Unproven sustainable practices.

Full compliance with local standards and regulations.

ESG Risk Group 4
Significant Risk

Material environmental liabilities.

High likelihood of increased regulatory scrutiny and proposed legislation.

Weak sustainable practices.

May not be in full compliance with local standards and regulations.

SOCIAL

  • Health and Safety
  • Labor Standards
  • Product Liability

Long history and future commitment to worker safety.

Financial ability and willingness to pay out retirement benefits and obligations.

Excellent labor management.

Excellent track record with Product Safety & Quality and Privacy & Data Security.

History and potential commitment to worker safety.

Financial ability and willingness to pay out retirement benefits and obligations.

Very good labor management.

Good track record with Product Safety & Quality as well as Privacy & Data Security.

May have had past issues with worker safety but proper measures taken.

Financial ability and willingness to pay out expected retirement benefits and obligations.

Satisfactory labor management.

Satisfactory track record with Product Safety & Quality as well as Privacy & Data Security.

Disregard for worker safety.

Questionable financial ability and willingness to pay out retirement benefits and obligations.

Poor labor management.

Poor track record with Product Safety & Quality as well as Privacy & Data Security.

GOVERNANCE

  • Corruption & Instability
  • Transparency/ Accountability
  • Business Ethics

Transparent corporate structure and ownership.

Strong evidence of fair treatment for all stakeholders.

Transparent accounting practices.

Minimal significant related party transactions.

Management is available and willing to meet with investors.

Transparent corporate structure and ownership.

Evidence of fair treatment for all stakeholders.

Transparent accounting practices.

Full disclosure of related party transactions.

Management is available and willing to meet with investors.

Largely transparent corporate structure and ownership.

Evidence of fair treatment to creditors.

Transparent accounting practices.

Full disclosure of related party transactions.

Management is occasionally available and willing to meet with investors.

Opaque corporate structure and ownership.

No evidence of fair treatment to stakeholders.

Questionable reporting or accounting practices.

Significant related party transactions with poor disclosure.

Management does not make themselves available to investors.

The assignment of individual ESG ratings will predominantly be the responsibility of the sector portfolio manager assigned to covering the security. To provide further focus on the ESG factors each portfolio manager will also address and document answers to the following questions prior to recommending the inclusion of any security into portfolios:

  1. What are the material ESG related risk factors associated with this investment?
  2. What is management’s response to these factors?
  3. How, if at all, is the company addressing or managing these specific risk factors?
  4. What is the probability and extent of downside risk associated with this investment owing to these ESG specific factors?
 
Engagement

We recognize as fixed income investors, that we do not have the voting rights that accompanies an active ownership stake in a company’s equity. However, as part of our Investment Process, we actively engage with issuers, through meetings with company management, investment roadshows, and onsite visits. The aim or our engagements is to both inform our risk assessment of the issuer, as well as to promote better disclosure of material ESG factors, when relevant. When we meet with the management of companies in which we rate their ESG factors to be poor, we endeavor to discuss with them how they are addressing these risks. The outcomes of engagements are shared across the team during formal and informal meetings.

 

External Supplementary Tools

In addition to our proprietary research into ESG related risks, we will all also use as needed screening tools and rating systems to identify ESG risk factors that may not have been captured through our own research. Such supplementary tools will be used to augment our research rather than serve as the key or sole ESG research engine.

 

Expected Impact of ESG Factors On Research Conclusions And Portfolio Construction

The determination of whether specific securities warrant inclusion in the portfolio is always an assessment of the risk adjusted return potential versus other investment alternatives as well as the impact on the return and risk profile of the portfolio in aggregate. The manner in which ESG related factors will impact security selection is qualitative. All else being equal, in the most straight forward of cases involving two securities that have the same return profile, but where one security has a superior ESG rating, the security with the superior ESG rating will be the one that is purchased.

As is the case with most investment decisions, considerable judgement will be required in weighing our clients’ interest in strong returns against the risk factors associated with the portfolio. As it relates to ESG related risk factors, our commitment is to ensure that such factors are properly assessed and taken into consideration when constructing and managing client portfolios. The elimination of ESG related risk factors in totality in our view is not possible. What is possible is that such factors are identified and vetted through the research function and brought into consideration in the portfolio construction process. We will work with clients on a case-by-case basis to determine whether additional ESG specific considerations should be taken into account in the construction of their respective portfolios (e.g., restricted security or industry list, prohibition of investments with an ESG Risk Group rating below 3).

 

Reporting

The following reports on ESG related research and risk factors can be provided to ESG sensitive clients:

  1. Breakdown of portfolio holdings by ESG risk rating 1 through 4
  2. Purchases and sales by ESG risk rating
  3. ESG related commentaries on portfolio holdings upon request
  4. Conference calls with a portfolio manager(s) to address specific questions related to ESG issues or specific holdings.
 
Summary and Conclusions

The identification and analysis of risk factors are important factors in the portfolio management process. The MacKay Shields High Yield team believes that ESG related factors, like any risk factor, can have a material impact on the long term return and risk profile of both individual securities and portfolios in aggregate. The team has always been committed to thoroughly researching all risk factors, ESG factors included, in the construction of client portfolios. The purpose of this policy will be to provide asset owners with greater visibility into how the ESG factors are integrated into our decision making process.