Environmental, Social and Governance (ESG) factors are most often discussed in the context of corporate and sovereign debt issuers, while they have been largely neglected when it comes to mortgage and other asset-backed securities. The main reasons for this include the complex legal structure of securitized transactions, which require multiple levels of due diligence by the investor to assess the sustainability characteristics of the underlying loans or assets, combined with the current lack of sufficient and granular ESG data for these underlying investments. However, we expect the quality and quantity of available information in this market to evolve rapidly, as client demand amongst institutional investors grows.¹

At Morgan Stanley Investment Management (MSIM), we believe that ESG considerations are an essential component to investing in securitized markets, and that a thoughtful ESG integration approach can result in better performance as well as better alignment with positive impacts on the environment and society. This is why we have developed a proprietary sustainability framework for our portfolios, leveraging the specialist knowledge of our analysts and investment team.

Our approach is based on three key steps, as presented in Display 1:

1.  In-depth analysis of the specific E, S, G characteristics of each deal;
2.  Scoring of the deal on a 1-5 scale, based on its overall ESG profile;
3.  Mapping of the positively- and negatively-scored deals to the applicable United Nations Sustainable Development Goals (SDGs), for consistent tracking and reporting of a portfolio’s overall sustainability.alignment

1.    ESG Analysis at the Deal-level

Our analysis begins by taking into account the nature of the underlying loans, borrowers, properties or assets, loan originators and servicers of every deal we assess, to identify the key E, S or G risks and opportunities associated with the collateral as well as the lending practices. For the evaluation, we rely on three primary sources for ESG information: deal documents, due diligence discussions with originators and servicers, and public announcements from the various government regulatory agencies.

Due to wide variations in the structure of mortgage- and asset-backed securities, ESG considerations can take different forms, as presented in Display 2, and we believe they can be directly linked to credit performance, impacting risk-adjusted returns both positively and negatively.

ENVIRONMENTAL FACTORS ARE EMPHASIZED IN OUR ANALYSIS OF COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS). Properties with potential adverse environmental impacts, such as large industrial plants, carry greater legal, default and liquidity risks. Conversely, we view buildings with Leadership in Energy and Environmental Design (LEED) or similar certifications based on environmental characteristics including energy and water efficiency in a favorable light, as we believe they tend to be associated with lower operating costs and higher occupancy and rental rates, translating to reduced credit risk for bondholders.

SOCIAL FACTORS ARE MOST RELEVANT WHEN ASSESSING RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS) AND CONSUMER LOAN ASSET-BACKED SECURITIES (ABS). Considerations for these types of deals are primarily related to the affordability of lending and the accessibility of the underlying loans to more vulnerable and underserved borrowers. However, the energy efficiency of properties and the environmental impact of collateral are also taken into account.

GOVERNANCE—IN THE FORM OF LENDERS AND SERVICERS’  PRACTICES  AS WELL AS PROPERTY OWNERS’ BEHAVIOR—IS AN ESSENTIAL COMPONENT OF OUR ASSESSMENT. This is aimed at avoiding exposure to predatory lending and mitigating litigation risk.

One of our integral due diligence questions asks about the current status of each lender and servicer with the Consumer Financial Protection Bureau (CFPB) and any other relevant regulatory agencies, to help us ensure fair lending and servicing practices are being applied. These details are tracked and documented by the investment team, as evidence of our regular screening for predatory lending across securitizations.

Based on our experience investing in this market, we find that ABS bonds where lenders or servicers face pending regulatory action have tended to underperform those with cleaner track records over the medium- to long-term. Servicers facing regulatory issues also can carry greater risks of potential disruptions in loan servicing activity which can also have a negative impact on loan performance. In addition, when underwriting standards are weak and/ or if predatory lending is occurring, loans usually have a higher risk of default. For on- going loan servicing, we evaluate payment collection processes and foreclosure practices. Aggressive payment collection processes and foreclosure practices can lead to more defaults and prepayments.

We also monitor the behavior of property owners and assess potential risks from their business practices and legal standing. This can be done via direct engagement with them, or by gathering additional information via third parties regarding eviction practices, environmental issues, and corporate governance. A pattern of  poor   business practices can indicate a heightened probability of legal issues which can affect loan performance.

2. MSIM’s ESG Scoring

Based on the analysis presented above, MSIM assigns an ESG score ranging from 1-5, 5 being best, to each deal. ESG scores are then applied to all tranches in a deal, based on the rationale that ESG factors are consistent throughout the entire structure. Some exceptions could apply, for example in the case of a rake in a CMBS deal, where a tranche within a larger deal is backed by different collateral than the rest of the deal.

We view most residential, commercial and consumer lending to have a neutral ESG profile, which translates to an average ESG scores of 3 across our investment universe. We have taken a conservative approach in this regard, by assigning a score of 3 to standard responsible lending practices, with the thesis that responsible lending should be interpreted as a baseline, while scores of 4 or 5 are reserved for lending practices and/or assets and loans with outsized positive environmental or social characteristics.

This is the case, for example, with buildings that have particularly robust LEED certifications (e.g. Gold or above, or equivalent), or ABS linked to renewable energy assets such as solar panels, which would be associated with a score of 5.

3.   Mapping SDG Alignment

The third and final step of our framework involves mapping the securitized portfolio to the SDGs as an indication of its positive or negative sustainability alignment.3 This is consistent with our broader sustainable investing approach at MSIM Fixed Income, which involves the monitoring and reporting of our portfolios’ net alignment with the SDGs across asset classes.

Our mapping is done by linking positively and negatively-scored deals to the respective granular SDG Target, and then aggregating the total contribution at the SDG Goal level. For example, RMBS or CMBS backed by certified green buildings contribute to SDG Target 7.3 – “Double the global rate of improvement in energy efficiency”, while solar panel ABS have a positive impact on SDG Target 7.2 – “Increase substantially the rate of renewable energy in the global energy mix”. Together, these investments count towards overall portfolio alignment with SDG Goal 7 – “Affordable and Clean Energy”.

Given the nature of underlying loans and assets, we find that most of the positive environmental contribution of our securitized portfolios tends to be related to SDGs 7, 9 and 13 on clean energy, sustainable industry and infrastructure, and climate action (specifically in terms of reducing carbon emissions). On the social side, our portfolios primarily contribute towards SDGs 3, 4, 10 and 11, with a focus on social wellbeing, access to and affordability of essential services.

A Flexible ESG Approach in an Evolving Market

Our MSIM Securitized Sustainability Framework is aimed at ensuring an objective and transparent ESG integration approach is applied across our mortgage- and asset-backed investments. Our approach also provides the flexibility, if desired by our clients, to tilt portfolios in favor of investments that have positive sustainability alignment. For example, as part of our sustainable portfolios that are allowed to invest in securitized debt, we aim at maximizing positive alignment by investing in deals with higher ESG scores, while minimizing exposure to negative scores.

Finally, we recognize that the measurement and evaluation of sustainability in the securitized market is evolving. We are actively engaging with leading ESG research and data providers, and collaborating with sustainability experts across Morgan Stanley, to closely monitor availability of new datasets that can facilitate deeper analysis, such as physical climate risk at the property level, or social impacts reported by lenders for their housing portfolios, and that can help us refine our scoring and mapping frameworks over time.

We believe the approach described above gives us a dynamic and flexible architecture within which to continue enhancing our sustainability integration methodology for the benefit of our clients and the strategies we manage for them.

¹ See “ESG Industry Engagement Survey 2020”, Structured Finance Association (November 2020).

² Acronyms: Consumer Financial Protection Bureau (CFPB); Office of the Comptroller of the Currency (OCC); Federal Deposit Insurance Corporation (FDIC); Department of Financial Services (DFS); Financial Servicers Authority (FSA); Financial Conduct Authority (FCA); Department of Financial Services (DFS); Prudential Regulation Authority (PRA); European Banking Authority (EBA); European Securities and Markets Authority (ESMA).

³ The United Nations’ Sustainable Development Goals (SDGs) are a global blueprint to achieve a better and more sustainable future by 2030. The 17 goals and 169 targets cover a broad range of sustainability issues, from eradicating poverty and hunger to affordable and clean energy, to good health and a quality education for all. The SDGs provide a framework to advance sustainable economic growth, gender equality and climate action, among other priorities. They increasingly inform and are used as an assessment framework for MSIM’s approach to investing, engagement and impact reporting.

Risk Considerations

ESG ratings are relative and subjective and are not absolute standards of quality. Ratings apply only to portfolio holdings and do not remove the risk of loss.

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of the Portfolio may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. ESG Strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Mortgage and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Due to the possibility that prepayments will alter the cash flows on Collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third party guarantees are insufficient to make payments, the strategy could sustain a loss. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk. Foreign securities are subject to currency, political, economic and market risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Inverse floaters are sensitive to early prepayment risk and interest rate changes and are more volatile than most other fixed-income securities.