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25 Jun 24 Insight Fixed Income Challenger Investment Management

ESG in ABS Investing

ESG integration within the securitised debt market is not as widely discussed relative to other asset classes and yet there are significant considerations in this space. Identifying ESG issues is important not only when reviewing transactions and the underlying loan portfolios themselves, but also when reviewing the origination processes used by the lender to market these loans and agree terms with customers.

Asset-backed securities (ABS) are bonds that are backed by a portfolio of assets, such as mortgages, auto loans, consumer loans, or corporate leveraged loans

Key ESG focus in ABS

Governance has always been a key focus for ABS structures given they have multiple counterparties involved in originating, servicing, rating, managing and investing into the underlying pool of assets. Weak governance within the counterparties or structure itself can lead to weaker asset performance than expected or uncertain outcomes. For example, poor governance within loan originators can lead to risk that the assets securitised are not as described or expected by end investors or rating agencies, increasing performance volatility ABS investors should also understand the potential for conflicts of interests between parties and how these are managed through the structure as they may arise.  Furthermore, data security and privacy are important as lenders have large data sets of borrower information and how they store and manage this data should be carefully scrutinised. Integrity and governance of these datasets and access represent risks as cyber security concerns increase.

Social issues are another topic of focus for ABS investors. Given ABS are backed by portfolios of loans originated by a lender, it is critical to evaluate the originator’s approach to responsible lending. This includes responsible marketing of products, ensuring consumers have all the relevant information on the loans into which they have entered, as well as fair treatment of customers if they fall behind on their payments and managing complaints. Lenders with weak approaches to responsible lending may increase their risk to potential future redress claims and their long term platform viability.  

Environmental issues are increasingly an area where there is more data and integration into the credit process. The geographical concentration of underlying loan pools is an important consideration, particularly in areas subject to extreme weather events. For example, areas of Australia have seen increased flooding and bushfires in recent years which increases the risk of losses within the loan pools. The sustainability of the loans being made also needs to be considered.  For example, a car loan provider may not be adequately covering the risks of the energy transition, technological developments or future demand for certain vehicle types, therefore potentially overestimating car residual values within their loan portfolio. Equally, there is scope for the development of specific ESG related asset backed securities featuring loan pools of environmentally beneficial assets such as household solar panels, heat pumps or electric vehicles.

How is ESG integrated into ABS in different jurisdictions?

Europe has been at the forefront of ESG integration in the ABS space over recent years. This has been driven by regulatory focus and investor demand, focused on data disclosures along with originator policies and practices. Most European ABS new issues marketing packs now include an ESG questionnaire in a standardised format completed by the asset originator. This means investors can receive detailed and consistent data across different managers and originators, which is fundamental to building a more knowledgeable and detailed framework to compare originators, managers and different practices within the market. Many European lenders are also starting to include reporting on underlying portfolios, such as the carbon emissions of car loan portfolios. Moreover, European CLO markets have adopted a different approach to address their unique characteristics, with some managers of leveraged loan portfolios including explicit restrictions in their documentation around investing in ESG negative sectors. Examples of these restrictions include investments in sectors with revenues linked to arms manufacturers, polluting industries or tobacco. 

Meanwhile, the US and Australia have lagged the European market.  In Australia, regulation such as sustainable taxonomies are being developed, which will provide definitions for what sustainable activities are and allow lenders to market ABS deals as green or sustainable with greater certainty. Further improvement in data consistency and regulatory approaches will be key to driving progress in Australia.

How does Challenger IM integrate ESG analysis?

The Challenger IM team has a systematic approach to incorporating ESG considerations into its investment process. As part of the due diligence, Challenger IM assesses the material E, S and G risks of an ABS deal. The team assigns a High, Medium, Low or ESG+ rating for each category based on the degree to which the factor affects the credit risk of the investment. Any investment with a High risk rating in any category is excluded and a Medium risk rating must be justified by the relative value of the investment or have the potential to be mitigated through engagement. Governance is a key issue when assessing ABS transactions and sharp scrutiny is applied to entities which have a Medium social or environmental risk layered with a medium governance risk. Challenger is more inclined to avoid these investments.

A cornerstone of Challenger IM’s investment capability is its expertise and deep relationships from its long history investing in ABS. Challenger has been investing in ABS since 2005 and currently has ~A$10bn invested across public and private ABS markets.  As a global team, Challenger can observe ESG developments in European and other global markets. Challenger’s ongoing dialogue and feedback with originators can be an effective way to improve processes and reduce the negative impact on borrowers. Examples of this engagement include requiring better governance structures within the company management of an originator and incorporating ESG issues in due diligence questionnaires.



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