Mind the gap: Creating an ESG framework for securitized assets

The securitization market accounts for over a quarter of the fixed income sector in the US, and yet integration of environmental, social and governance (ESG) measures remains a work in progress. Although the financial crisis of 2008 highlighted major need for responsible lending and servicing behaviours, predatory practices such as loan churning and excessive rates have shown to remain.

The market faces a unique set of challenges including:

1. Complexity of securitized assets due to their nuanced history and involvement of multiple parties
2. Opacity and lack of transparency relating to the unavailability of data regarding the parties involved in securitization, and
3. Objectivity due to the dearth of third-party ESG score providers

However, as more investors embrace impact investing, seek long-term value and identify risks related to socially responsible practices in securitized products, the need for transparency, clear frameworks, and metrics grows. A 2020 FTSE Russell survey^[1] found that interest for ESG considerations in fixed income significantly increased (58%) along with multi-asset (31%) applications. In the wider market, green bond issuance annually surpassed the $0.5 trillion mark in 2021 and is expected to hit $5 trillion by 2025, according to the Climate Bonds Initiative.

To plug this gap, Yield Book launched the ESG framework for securitized assets – the world’s first available set of ESG credentials of its kind, earlier this year. Taking a purely quantitative approach and testing hypotheses using 20-year historical agency and non-agency loan level data, Yield Book has created a rigorous process and robust data to drive transparency in fixed income sustainability assessment, with the aid of the latest technological advances.

The framework aims to address the need for a consistent and holistic view of ESG within securitized products, including but not limited to the below (see exhibit 1), which would then assist lenders and servicers throughout the entire investment process, and are computed separately for both parties. Different actors can attribute different weights to these, depending on their goals.

So, what does this mean for investors?

Proactive monitoring

To ensure investments generate a positive and measurable ESG impact, provide a sound financial return and comply with the developing regulatory landscape, investors can closely track and monitor their portfolio’s ESG credentials using data sourced from Yield Book, Beyond Ratings and Refinitiv. Our platform facilitates access to over 500 ESG metrics at the single bond and portfolio level with transparency into underlying drivers, alongside financial considerations. Within this framework, ESG risk integration can occur at a transaction and collateral level, and at a deal structure level where relevant and material.

In practice (see exhibit 2), this means that investors can closely observe the dynamic impact of changes in security allocations, create stress testing and optimization of portfolios. Individual index constituents along with their ESG scores can be tracked and used for benchmarking needs.

For example, investors can use Yield Book’s models to examine lenders for a substantial percentage of their production in significant delinquency. This can help investors avoid lenders with high percentages of early pay default risk (EPDR)^[2] as significant delinquency in recently originated loans is an indicator of a troubled situation.

Pre-emptive action

Yield Book’s ESG framework for securitized assets allows for the detection of responsible lending and servicing behaviors - or lack thereof - key to understanding the full dynamics of the market.

Investors can flexibly incorporate sustainability and/or governance goals into single securities and portfolios and include detection of metrics like loan churn and early pay default risk to raise red flags. Then, investors can be poised to act when a single bond or portfolio moves out of sync with their final ESG and financial goals.

For example, investigating lenders that systematically originate loans with outsized rates^[3] can be used as a governance metric within the Yield Book’s ESG framework for mortgage-backed securities (MBS).

Yield Book’s models – using around 12 million rolling datapoints – can make tight and symmetric predictions regarding a systematic deviation from the norm (see exhibit 3) that would signal the occurrence of problematic behaviour in the market. In some cases, by no fault or predatory intentions, a lender’s production will fall to the right side of zero indicating the actual rate is higher than the predicted rate. However, when a significant portion of a lender’s production falls to the right side, this indicates evidence of systematic lending at rates above what can be justified by borrower characteristics or market conditions.

As regulation around ESG practices evolves and uncertainties like climate change reshape investment practices and global market trends, investors can seek to manage risk by leveraging quantitative ESG-related insights and maintaining deep portfolio analysis to assess ESG impact across asset classes in the fixed income universe.

For more information on the ESG framework for securitized assets, visit our page Yield Book Sustainable Investment Analytics.

References:

[1] https://www.ftserussell.com/research/smart-sustainability-2020-global-survey-findings-asset-owners

[2] https://solutions.yieldbook.com/content/dam/yieldbook/en_us/documents/publications/responsible-lending-behavior-metrics-scores-epdr.pdf

[3] https://solutions.yieldbook.com/content/dam/yieldbook/en_us/documents/publications/responsible-lending-behavior-metrics-scores-outsized-rates.pdf