The revelation that Volkswagen (VW) has been systematically defrauding environmental regulators (and thus customers) across the world has two main lessons for credit investors. While neither of these lessons is new, this is a timely reminder of both.
1. Companies are not run for the benefit of bondholders
In most jurisdictions, company directors are not required to act in the best interest of creditors unless the firm is insolvent. In VW’s case, whether this fraud was known at board level or not, it is clear that a culture existed that focused on profit first and foremost i.e. making the shareholders, and likely management of the firm, rich. While the agency issues of management versus shareholders are well documented, the impact on bondholders of this type of activity is less understood.
Presumably the motivation for their activity stemmed from the cost savings, and hence increased profits, of rigging the emissions testing compared to building the cars, with the same power and fuel economy, that actually complied with the standards. Assuming that this was a deliberate corporate strategy to defraud regulators, there could be one of two possible outcomes for the firm. Below we consider the return profiles for both equity and bondholders in these outcomes, acknowledging that there is always an unknown, but non-zero, probability of being discovered.
Possible outcome 1: they continue to get away with it, thus profits are boosted and shareholders win. Dividends and share prices would continue to rise and hence the owners benefit from the reward of taking the risk (of getting caught).
Possible outcome 2: they get caught and they face large fines, restitution costs, brand damage and possible longer term viability issues for their firm. Clearly here, equity holders have borne the cost of the losing bet.
Now look at this from the perspective of bondholders. Outcome 2 clearly impacts bondholders negatively. The value of the company’s bonds falls (as credit spreads widen), their credit ratings are downgraded, and bondholders too, face the heightened probability of future distress for the firm.
But what about outcome 1 – do bondholders win or lose? Clearly the benefits of increased profits go completely to shareholders – so bondholders do not win as a result of not getting caught. But further, to the extent that the firm looks to be more profitable than it really is, this will, all other things being equal, result in credit analysts assessing the firm to have a lower default probability than it really does. The implication is that bondholders actually lend to this company at a lower rate than they otherwise should. Hence bondholders are not being appropriately compensated for the true risk they are exposed to and in turn receive lower returns.
While equity holders face a symmetric outcome, winning under outcome 1 and losing under outcome 2, bondholders lose under both!
This example highlights the need for investors to, as fully as they can, incorporate environmental, social and governance (ESG) risk assessments in their credit process. Directors at VW either created a culture where the imperative to achieve performance targets overrode any requirement to remain within the law, or they were blind to the weaknesses in their own governance framework. Companies who control these risks poorly will often manage other risks poorly, resulting in significant financial impacts on the firm. Whilst such analysis will not always uncover these risks (as is clearly the case with VW), the risks are real and can rapidly convert into financial risks.
2. Diversification is the ultimate protection against shocks
Recent high profile corporate scandals, such as the BP oil spill in 2010, have been accompanied by commentary and analysis around whether it would have been possible for a credit analyst who ‘knew the company’ to have identified, ex-ante, the issues around this company. While no analyst would ever have predicted the Gulf of Mexico disaster, it is possible to argue that some of the risk factors were more visible in the VW case.
While VW had some visible governance issues around it – a single shareholder block holds 90% of the voting shares, non-independent majority on the board, no fully independent audit committee nor independent remuneration committee – these are not all that unusual in many bond issuers. Despite these issues, it would be highly unlikely that any credit analyst, who really dug deep into and ‘knew’ VW, would have identified that the firm was undertaking such a widespread fraud on its customers.
Such an unexpected outcome, especially given the asymmetric return profile explained above, clearly argues against credit approaches that rely on ‘really knowing a company’ and holding large concentrations in them.
In debt, concentration is an unrewarded risk. The best way of managing credit portfolios, where outcomes like the VW case can, and do, happen is to build highly diversified portfolios.
To summarise:
- Shock events like the VW emissions scandal are almost impossible to predict. Even the best analysts are unlikely to ‘know’ a company well enough to uncover this level of fraud.
- Likewise, the best ESG processes would not have discovered the ‘diesel dupe’, but rather are more likely to pick up governance issues supporting a culture for unlawful practice.
- Bondholders will lose in these scenarios as companies are run to benefit shareholders, not bondholders.
- The best way to limit the impact from these shocks in a corporate bond portfolio is to diversify. Hold a little of a lot so that losses due to a big event / default are limited, minimising the impact to your overall return.
Tony Adams is the Head of Global Fixed Income and Credit for Colonial First State Global Asset Management. This article is for information purposes only and does not consider the circumstances of any investor.