Environmental, social and governance (ESG) factors are all important to the sustainability of an investment. Governance may be listed last, but it should never be an afterthought for fixed-income investors. After all, by studying an organization’s governance—the practices and processes used to direct and manage the organization—investors gain vital insight into a country’s or company’s ethos, risk management and overall sustainability.
Bond and Equity Investors Agree on Governance Basics
Equity and fixed-income investors agree that good governance includes fair treatment of stakeholders, accurate and transparent reporting with appropriate disclosures, and minimal conflicts of interest between management and the company. Unfortunately, not all companies rise to these standards.
Consider Carvana, a web-based used car seller, whose bonds have underperformed their CCC-rated peers. The ownership structure includes super-voting shares for the CEO and his father, the company’s largest shareholders, granting them control of the company. The company has relied on ongoing equity offerings to fund itself, which can limit access to capital in the future. And with limited shares available for trading, the stock price and market value have fluctuated wildly. The biggest red flag for us, though, is the CEO’s father’s bank fraud conviction in 1990. The two men remain very close, and the company’s control structure combined with the fraud conviction casts a shadow on company financial statements.
But Fixed-Income and Equity Investors Have Differing Needs
Even when governance is good for equity investors, it isn’t always good enough for credit investors. Bond investors are primarily concerned with reducing risk to their investment, while equity investors focus on increasing returns. Equity investors, for example, might be happy for management to spin off valuable brands to shareholders. However, unless the spin-off assumes a pro rata share of existing debt, leverage and default risk increase for creditors of the remaining company. Shareholders might even ask management to fund significant dividends with debt, which harms credit investors by transferring capital from the company to equity shareholders.
Credit investors need to know that the organization will protect their standing in the capital structure. This is never more critical than during a leveraged buyout (LBO). When the potential LBO of Kohl’s was announced, the share price rose 36%, while the price of bonds maturing in 2037 dropped 10%. Not only would credit investors face increased debt to fund the buyout, but there is also speculation that the acquirers might sell off and re-lease the company’s real estate, reducing the assets available to credit investors.
Trust, but Verify
Strong covenants are essential for bond investors. Every bond issued is a contract between the issuer and the buyer. In addition to stipulating coupon, maturity and par value, the bond’s prospectus almost always contains covenants. Covenants lower borrowing costs for issuers and provide an additional layer of protection for bondholders by limiting the issuer’s ability to take actions that favor another party over the bondholder. Covenants are guardrails, and issuers take these commitments seriously. If an issuer violates a material covenant, the bond may enter technical default, often leading to a rating downgrade and higher borrowing costs.
Investors need to inspect covenants carefully for potential loopholes, however. For example, a common loophole in high-yield bond issues is a covenant that limits a company’s secured debt but doesn’t mention unsecured debt. Companies use this weakness to load the balance sheet with unsecured issues—making the secured debt risk profile significantly better than the unsecured.
Another loophole is one that allows the interests of equity investors to be placed above those of bondholders. Take Party City, which earned a mid-range governance score by a data service but scored much lower under our credit-centric analysis. Why? The pandemic forced the company to close stores for three months in 2020, worsening its already precarious financial situation—the company has a debt-laden balance sheet from its private equity acquisition in 2012. In May 2020, the cash-strapped company asked holders of bonds due in 2023 to exchange them for a new issue due in 2026—at a discount to par. Investors who refused now own bonds that are deeply subordinated to the new 2026 maturity and trading materially lower than similar unsubordinated bonds.
About Those Data Services
Fixed-income investors might wonder why a fundamental assessment of governance is necessary, given bond ratings and ESG data services. These are useful, but their flaws mean that investors must scrutinize governance themselves. Both ratings companies and ESG data services use proprietary methodologies, so they lack transparency and comparability. Plus, ESG services consider governance from an equity investor’s perspective. The result? Their scores come up short from a credit investor’s perspective, and they overlook much of the fixed-income universe, where privately owned companies haven’t issued equity.
Even when rating services have rendered an opinion, original appraisals can be deficient, and situations can deteriorate rapidly. For example, Suriname issued a sovereign 10-year bond in 2016 and a four-year bond in 2019. ESG data services gave the country a governance score at the low end of mid-range. But the availability of the country’s economic and financial data quickly deteriorated after the initial offering, and it appeared that the government would wait to disclose information until it could post a positive quarter. The government was also reluctant to disclose policy plans with investors and pressured local banks to purchase government T-bills at levels above their risk management limits.
An investigation into the country’s political leadership would have indicated that stewardship was suspect: Dési Bouterse, the country’s president from 2010 to 2020, was a former coup leader with convictions for cocaine smuggling and murder, and ties to organized crime. During his tenure, international reserves dwindled, black market exchange rates spiraled and public debt rose from 15% to almost 150% of GDP. The bonds already traded at wide spreads when the pandemic began, worsening an already distressed economy and causing a further hit to bond prices, which fell to 30 cents on the dollar. Suriname officials have failed to reach a restructuring agreement after two years of negotiations.
Integrating governance into the investment process isn’t just about optics. Governance reviews beyond data provided by agencies and services can uncover hidden ethical or structural risks. Governance can also ensure that the issuer’s interests align with those of the bondholder. And no investor wants to find out after the fact that an issuer has poor governance. The difference between a good investment and unexpected losses might come down to the issuer’s governance practices.