Case study by Addenda Capital
|Contributor||Dan Lavric, CFA, Portfolio Manager, Core Fixed Income, Addenda Capital|
Market participant type
US$20.9 billion (as of 31/12/2017)
Fixed income AUM
US$14 billion (as of 31/12/2017)
Case study focus:
Example of how S and G factors affect credit risk
Background to the investment case
CoreCivic is the largest non-government owner of correctional and detention real estate in the US. CoreCivic develops, owns and operates prisons and jails for US government entities. As of 31 December 2017, CoreCivic owned and managed 70 real estate assets and 12 more properties leased to third parties. CoreCivic’s long-term debt is not considered investment grade by Moody’s (Ba1) or S&P (BB) but its ratings steadily improved from 2000 through 2016, at which time both agencies downgraded the company. In October 2017, the company announced the issuance of US$250 million of senior unsecured notes due in 2027.
CoreCivic’s main competitor is The GEO Group, which has an enterprise value roughly one-third larger than CoreCivic’s. The company’s larger peers are generally not investment grade, while its smaller peers are mainly private and unrated, relying primarily on bank funding.
ESG factor which drove the investment decision
The sustainable investing team worked with the core fixed income team to arrive at the investment decision, which was to not participate in the issue. A portfolio manager in the core fixed income team had been looking at the investment opportunity and reached out to the sustainable investing team for ESG research on CoreCivic. Although the finances, business model and valuation were initially promising, research on ESG risks caused the team to change their minds and rule out the opportunity.
There were multiple ESG-related investment concerns including that the company had changed its name to rebrand its image, raising a red flag. The issuer had been trapped between two activist groups: one that demands more spending on prisons (citing poor living conditions, understaffing, human rights violations) and another demanding less spending on prisons (citing high operating cost/detainee, high US incarceration rate). This could be a future risk for profit margins. Additionally, recent cases of activist groups trying to vilify CoreCivic’s lenders could cause reputational damage to future investors.
Another concern was that, in 2017, New York City’s pension funds made the decision to sell their investments in private prison companies. The main reason was the record of alleged human rights abuses and the risk of the industry experiencing “long-term reputational and financial harm”. These issues could cause lower demand for CoreCivic’s bonds and in turn damage valuation.
Lastly, limited disclosure by CoreCivic regarding ESG factors – despite calls for greater transparency – mean many unknown unknowns may be uncovered in the future, should disclosure improve.
Between when we started following CoreCivic and the writing of this note, the yield spread over US Treasury bonds on the company’s longest maturity bond (2027-10-15) widened by 45bps, equivalent to a 3.3% price erosion due to spread widening (see figure below).
Our expectations about ESG risk being concentrated in the industry as well as the issuer appear to have been warranted, as the spreads of a similarly termed bond from its main competitor, The GEO Group, also widened (by 49bps). By contrast, the spread on the US high-yield market widened by only 8bps (from 348 bps to 355bps) over the same period.
This investment case helps further convey the message that even when the business model, finances and valuation of an investment seem attractive initially, sustainability considerations can change the big picture and thus change an investment decision. Even before traditional financial metrics worsen, sustainability considerations can affect investment decisions. In the case of CoreCivic, the considerations were a mix of concerns about the company’s governance and business model.
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Shifting perceptions: ESG, credit risk and ratings – part 2: exploring the disconnects
ESG, credit risk and ratings: part 2 - exploring the disconnects
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Case study: CoreCivic