Why money market instruments are exposed to ESG risks

Environmental, social and governance (ESG) factors are generally linked with long-term issues, in part because ESG integration into the investment process has evolved with the market’s recognition that a company’s long-term strategic focus on corporate sustainability can enhance its risk-return profile.

That said, ESG risks are in fact relevant for short-term investments including money market funds, which changed substantially in 2008 when the short-term profit focus of major financial institutions met the rigidity of the bond rating process and overall investor inertia.

Depending on the triangle of “timing”, “materiality” and “probability”, a potential negative ESG event will likely have impacts on money market instruments, making ESG risks an indispensable consideration in the liquidity space.

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Federated Hermes demonstrates why short-term securities are exposed to ESG risks by shedding light on the three dimensions. It also explains the imperfection of relying solely on third-party ratings and how to better manage the ESG risks.

Timing

Money market funds can mature overnight and typically within a year. Despite the short-term nature, those instruments might still be exposed to adverse ESG events, because the underlying issuer or collateral is exposed to ESG risks.

Liquidity portfolios only hold specific issues for a relatively short period of time. That said, rolling over issuer paper is commonplace and necessary in these highly regulated portfolios. Although there is a credit assessment applied each time when a rollover happens, names on the approved credit list tend to be quite stable in most market environments, effectively making money market and other liquidity funds “long-term” investors.

This is a key factor in the short-term investment space. The timing of an ESG risk materialising into an event with significant financial consequence is not predictable. As soon as an issuer, whether it is a global bank or a corporation, is hit by an ESG event, it does not matter which security it is. ESG events affect issuers, and thus ultimately affect the issued securities, be it a bond, a share of stock, repo, or commercial paper.

Materiality

Different industries and sectors are exposed to different ESG factors. One ESG factor might be financially material to one industry while it is irrelevant to another. An often-quoted example is the oil and gas sector, which traditionally has been claimed to be relatively more exposed to environmental issues than, for example, the financial services industry.

The key in determining which ESG factors are relevant for an issuer is financial materiality. Financially material ESG factors for issuers also play a role for liquidity funds as they can have immediate implications on an issuer’s riskiness. They should be considered as part of the high quality, minimal credit risk assessments, but unfortunately this is not the case in traditional credit rating.

To identify material ESG factors for an issuer, it is important that investors form their view of what they deem to be important from an ESG perspective for a sector and not rely solely on third-party ratings.

Probability

The likelihood of an ESG event happening is difficult to gauge, but this is also the case for estimations of default and credit downgrade probabilities. Still, it is important that credit assessments in money markets take the probability of an ESG event into account, like they do for the probability of a credit downgrade or distance to credit downgrade calculations.

Ultimately, the higher the likelihood of an ESG event to affect an issuer, the higher the default probability. Several corporate scandals in the past have demonstrated the adverse financial impacts that ESG events or controversies can have on issuers. ESG ratings and additional qualitative insights into a company’s ESG practices through means like issuer engagement are useful ways to help enhance a view about an issuer’s ESG riskiness and the likelihood of an ESG event.

ESG integration

The timing, materiality and probability of a negative ESG event can be difficult to predict and stringent analysis of ESG factors in security selection is required.

At Federated Hermes, the team believes that the combination of deep ESG analysis and impactful engagement, also called “stewardship”, is the only way to make genuine ESG integration possible.

Combining ESG analysis on an issuer level with direct engagement with corporate issuers and global banks is the only way to effectively integrate ESG into money market and liquidity portfolios.

Federated Hermes maintains high quality, minimal credit risk requirements in money market fund investments, in addition to the objectives of principal stability and liquidity while maximising the risk-adjusted return.

Find out more about Federated Hermes liquidity capabilities here or contact:

Mark Coppell
Director - Global Liquidity Distribution, Asia Pacific
Phone: +65 6850 0672
Mobile: +65 8182 7726
Email: [email protected]

^Disclaimer:

^{The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.}

^{Distributed by the international business of Federated Hermes (“Federated Hermes”).The main entities operating under Federated Hermes are: Hermes Investment Management Limited (“HIML”); Hermes Fund Managers Ireland Limited (“HFMIL”); Hermes Alternative Investment Management Limited (“HAIML”); Hermes Real Estate Investment Management Limited (“HREIML”); Hermes Equity Ownership Limited (“EOS”); Hermes Stewardship North America Inc. (“HSNA”); Hermes GPE LLP (“Hermes GPE”); Hermes GPE (USA) Inc. (“Hermes GPE USA”) and Hermes GPE (Singapore) Pte. Limited (“HGPE Singapore”). HIML and HAIML are each authorised and regulated by the Financial Conduct Authority. HAIML and HIML carry out regulated activities associated with HREIML. HIML, Hermes GPE and Hermes GPE USA are each a registered investment adviser with the United States Securities and Exchange Commission (“SEC”). HGPE Singapore is regulated by the Monetary Authority of Singapore. HFMIL is authorised and regulated by the Central Bank of Ireland. HREIML, EOS and HSNA are unregulated and do not engage in regulated activity.}

^{The ESG ratings assigned are one consideration among others as part of the security selection process and do not represent an assessment of the fund itself. The qualitative analysis described does not automatically result in including or excluding specific securities but is used as an additional input to improve portfolio risk/return characteristics. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Nothing contained in this paper should be construed to suggest that Federated Hermes or any particular affiliated funds employ or are obligated to provide the service or analysis of factors described herein.}