Debating the ESGs of ABS
June 2022
What We’re Watching – May 2022
While the responsible investment revolution is well established in traditional fixed income markets, there are many parts of the market where standards are far less developed. Following a recent transaction which ignited some debate within the team, we decided to share some of the discussion that ensued.
This month, Victoria Gao, a portfolio manager in the ABS team will discuss all things ESG and ABS with myself. The deal that first inspired this debate was the first issuance of a social residential mortgage-backed security in the domestic market. This type of deal is ostensibly pitched as a social bond as the mortgage loans are specifically targeted towards borrowers for whom access to finance is challenging.
So Victoria, what is your take on this type of product?
Victoria: This social ABS bond funds mortgages to underserved Australian owner-occupied borrowers such as those with credit impairment (e.g. due to divorce) or are self-employed. The transaction did not include refinance customers. [In our view] it was a good market development initiative by the issuer – not only to implement a social RMBS framework, but also to increase market awareness of the importance of socially responsible funding. As the first social bond, we’d expect constructive market feedback to evolve the programme as it matures; and coming to market provides the Issuer with direct investor feedback.
Pete: Okay that’s interesting Victoria. The challenge here is making sure the deal is increasing availability of credit to underserved borrowers and in doing so, reducing inequalities which is UN Sustainable Development Goal number 10. It strikes me that this linkage between availability of credit and reducing inequalities is somewhat tenuous; indeed, in the Global Financial Crisis we saw over-availability of credit ultimately lead to increased inequalities. As you say, the emergence of social RMBS is a positive step in the right direct, but how do you see these deals evolving in the future to ensure that they do meet the goal of actually reducing inequalities in society?
Victoria: That’s a good question. It’ll be good to see clearer differentiation of how these borrowers will be treated (compared to other borrowers) and additional reporting to quantify the benefit on a loan-by-loan basis. The first step is enhancing the system capability to flag borrowers, including social-related borrower attributes.
Furthermore, we understand that there are aspirations to provide price discounts which could further assist select underserved borrowers. A policy that outlines the target demographic upon the inception of the loan – such as a net wealth or asset test, or whether they are an existing home owner – could directly demonstrate the reduction of inequalities outlined in the UN sustainability development goals. There is an eligibility criterion in place in the recent social bond that limits loan size to $1.25m; however, a greater understanding of the specific borrower demographics in future transactions would be beneficial.
Pete: I think these developments are going to become very important for investors. A key risk I see from an investment standpoint is that these deals may not always be “social”. For example, if a borrower enters arrears how are they treated? If their interest rate increases immediately, hardship is refused and the property is repossessed then it is hardly aligned with SDG 10 anymore. In this case you run the risk of the market deciding that the bond is no longer socially responsible which could impact the secondary market pricing and liquidity of the deal. How do you think investors can manage this type of risk?
Victoria: Arguably, the best way to manage this type of risk is to have a strong arrears and hardship policy and a well trained servicing/collections team. As I mentioned earlier, a potential evolution could be a hardship policy that differentiates how these social-mortgages will be treated, so to better reflect the increased sensitivity needed. Another important factor will be the underwriting – the Originator will need to demonstrate that despite the social overlay, the quality of the underwrite is maintained and that these loans are still suitable under responsible lending (including adequate buffers in a rising interest environment). Disclosure of the approach taken in such circumstances ensure transparency, so for investors to make a fully informed decision on their internal ESG rating.
Pete: Totally agree with the point about transparency; it is absolutely key to assessing these deals. I’d also add that having confidence in the governance of the business is also crucial. Management and shareholders in these businesses need to acknowledge that issuing social RMBS places obligations on them to interact in a socially responsible way with their borrowers, and not just at the inception of the loan.
One thing that we haven’t yet discussed is the potential incremental credit risk of a social RMBS. Unlike a green RMBS where you might argue that borrowers in houses which are more environmentally friendly are better credits or that the houses themselves will retain more value, in a social RMBS you are targeting your lending towards what is probably a weaker cohort of borrowers than the average pool. So potentially a social RMBS deal has a riskier pool of credits than a non-social RMBS. Is that fair or would you argue that there are mitigants to the risk of a social RMBS?
Victoria: That’s a good point. Unlike a green ABS where the underlying asset is green, this social bond focusses on borrowers with credit impairment or are self-employed; I agree that compared to PAYG, clean credit borrowers, this is a weaker set of borrowers. However, this is the exact reason why such borrowers may have difficulty accessing credit in traditional means and there is merit in creating a market to assist true underserved borrowers. To the extent that the issuer can better demonstrate and quantify the social benefit, for example with the aforementioned developments, I think there will be a better case internally for investors to directly show the ESG impacts.
In terms of mitigants, rating agencies penalise credit impaired and self-employed borrowers via their default frequency multiple – and this was notable in the social bond transaction which saw higher required credit enhancement, thus increasing the protection for investors. Additionally, it is important to note that there are favourable attributes in such pools, for example all owner occupied and lower maximum loan size (less pool concentration) which are viewed as traits that reduce the credit risk. To the extent that we do not consider the structural protections to be commensurate of the risk, it is reasonable to expect investors to reflect it in the price.
This transaction is one way to approach social ABS. It will be interesting to see in future broadening to other types of social ABS, such as funding social housing. Overall, these are all positive steps towards reducing inequalities as outlined in the UN sustainability goals; and the market should come together and provide feedback on how to improve the social ABS framework in a consistent way.
Pete: I think the point around mitigants is a good one. As an investor you are benefitting from increased levels of credit enhancement to offset the potentially greater levels of credit risk. I think if issuers are really committed to this product they could go even further with a deeper underwrite which could include financial counselling both at inception or on an ongoing basis.
Your comment around the broadening of social ABS also reminded me that these deals have really significant benefits across wider society as well. Viewed through the lens of the UN SDGs they can address inequalities as you have already mentioned, but also things like gender equality (loans specifically tailored to women) and sustainable cities and communities (social housing loans). I think in this respect there is also a role for public capital to invest alongside private capital to support these goals. The SME Recovery Loan Scheme established by Treasury during the Coronavirus pandemic could be adapted for social lending where the government guarantees a share of the loan balance.
At this point all there is to say is thanks so much for your input this month Victoria. There is so much activity in the sustainability space which will create opportunities as well as risks for investors. Thanks for helping us unpack just a little bit of it.
Pete Robinson
Head of Investment Strategy – Fixed Income
Victoria Gao
Portfolio Manager – DABS
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