Why Municipal Bonds?
Municipal bonds are debt securities issued by states, municipalities, or not-for-profit organizations to finance their capital expenditures, which include projects such as public transportation, bridges, schools, and clean water treatment facilities, as a few examples. Most investors utilize municipal bonds for capital preservation and current income, as well as for tax efficiency in the case of tax-exempt municipal bonds.
The $3.8 trillion U.S. municipal bond market1 plays an important role in funding important projects and public infrastructure that reach millions of individuals in communities across the country. There are over 50,000 issuers of municipal debt in the U.S.2 and the vast majority are considered investment grade. Tax-driven reasons aside, given there are both tax-exempt and taxable issuances in the market, municipal bonds are an attractive option for investors seeking a fixed income solution that has lower correlation with fundamentals of corporate debt and equity, which can help enhance portfolio diversification. Municipal bonds, on average, have experienced historically lower default rates than their similarly rated corporate bond counterparts, making them an appealing investment option for quality-conscious investors.
U.S. Municipal Bond Market1
Issuers of Municipal Debt in the U.S. And the Vast Majority Are Investment Grade2
Furthermore, for inherent reasons, use of proceeds and the geographical place of the investment are relatively identifiable for investors, especially when compared to most corporate bonds. These intrinsic characteristics of municipal bonds make them attractive to consider as impact investments. Impact securities are investments made with the intention to generate positive social and environmental impact alongside a financial return.3 Like many investors, we have found the UN Sustainable Development Goals (SDGs) to be a helpful framework for communicating impact objectives and connecting them to investable opportunities.
The Neuberger Berman Municipal Impact strategy targets the social and environmental impact themes of: (i) improve sustainable growth and employment (which includes access to basic needs such as housing and education), (ii) improve health outcomes, (iii) address climate change and energy needs, and (iv) conserve the natural environment.
Neuberger Berman Municipal Impact Framework
In order to assess fit for the Municipal Impact strategy, we seek to understand the potential impact of a particular bond issuance from multiple angles. We analyze three key pillars: the issuer of the bond, the use of proceeds, and the place where bond proceeds are invested.
The Neuberger Berman Municipal team first began sustainable investing over 10 years ago through our joint investing with the Neuberger Berman Sustainable Equity team for clients seeking balanced portfolios. Following years of refinement, today we apply a three-pillar methodology that drives our impact framework:
- Sustainable Issuer – to what extent is the issuer sustainable with respect to governance, fiscal responsibility, and management of material social and environmental issues?
- Use of Proceeds – will the debt proceeds be used for a project that is essential, significant, and overall positive?
- Place-based Potential for Impact – does the project target a geographic location that is believed to have a higher relative need?
1) Sustainable Issuer
We assess whether the issuer is well managed with respect to governance, fiscal responsibility, and management of material social and environmental issues. This analysis builds on our standard ESG assessment that is integrated throughout the broader municipal platform to inform credit risk and relative value. Good governance of municipal issuers encompasses a number of important factors from prudent long-term financial management to sound policy decisions and management of material environmental and social considerations. On the financial management front, we believe that creating structurally balanced budgets is critical. We seek to understand how budgets are managed and whether one-time actions such as asset sales or cost cuts that are unsustainable are utilized in the budget process. Regarding policy decisions, we seek to understand whether capital spending on projects have a positive effect on the broader community or are politically motivated and only benefit a narrow set of corporate constituents. Governance is the means by which social and environmental outcomes are achieved; good governance and management can lead to overall positive outcomes for the community. On the other hand, poor governance and management can lead to overall negative outcomes for the community–the water crisis in Flint, Michigan is an example of how poor decision-making and governance led to a situation of contaminated water which is detrimental to people and the planet, not to mention the long-term negative health outcomes experienced by the residents of the city.
We believe the State of California is a good example of an issuer that exhibits positive sustainable attributes. Until the recent gubernatorial administration, the state’s financial management practices at times led to financial stress even during periods of economic stability. However, the current governor and management team have pushed for a structurally balanced budget process while funding environmental and educational programs that are beneficial to the broader public. Today, California is among the strongest states in terms of credit fundamentals and overall financial health whilst supporting programs that deliver positive social and environmental outcomes.
2) Use of Proceeds
Every project has a range of impacts across all stakeholders–including both people and the planet. We seek to understand both positive and negative social and environmental effects to determine the “overall impact” of a project across a spectrum. Our Municipal Impact strategy aims to target positive outcomes to support economically, socially, and environmentally sustainable communities across the U.S. For example, projects that reduce greenhouse gas emissions or landfill, or contribute new K-12 public classrooms to a community with overcrowded schools, would be considered significantly positive on the spectrum of use of proceeds. On the other hand, there are uses of proceeds for municipal bond issuances that we believe have an overall negative or neutral effect. Most general governmental use of proceeds would be considered neutral given how challenging it can be to pin down the specific use of proceeds for most general obligation bonds and because the range of effects on stakeholders is so varied that ultimately the overall impact of a project can be “it depends.” This is why we believe the fundamental bottom-up approach and judgment of our research analysts is so critical to our analysis.
There are some interesting projects in the municipal space that contribute to positive environmental outcomes, particularly in the high yield municipal market. For instance, a project that promoted a circular economy and better health outcomes is one that converted agricultural waste to structural lumber to be used in the interior of residential homes. The product was repurposed for architectural moldings and wood flooring. Historically, this agricultural waste was burned, which was detrimental to the atmosphere and federal law eventually banned this practice. However, the agricultural waste then went to landfills. By repurposing the agricultural waste to a useful building material to replace traditional wood, landfill buildup was reduced, and deforestation was mitigated. Furthermore, the agricultural waste material was not prone to absorbing moisture like traditional wood, and therefore, harmful preservatives such as formaldehyde were no longer necessary, avoiding both environmental and health-related negative outcomes.
3) Place-based Potential for Impact
By proactively targeting geographic locations that are believed to have a higher relative need, an investment in the same use of proceeds can perhaps go even further. For example, school classroom construction bonds that are invested in a low income community where overcrowding is an issue can contribute to a solution. While the construction of facilities on its own does not solve the achievement gap, using municipal bonds as a financing tool enables the deployment of capital to incrementally alleviate the problem. An important dimension of understanding the potential impact of a project is to assess who is being affected by the use of proceeds and how in need they are. We rely on data that is publicly available as a proxy for relative need of individuals in a community.
Place-based investing refers to the geographically focused deployment of capital across asset classes to improve the local community. Many foundations (both community and national), community development financial institutions (CDFIs), anchor institutions (including universities, health systems, and large corporations with significant local footprints and employee bases), have embraced place-based investing. Similar to the asset class of real estate, municipal bonds often finance facilities that have a physical location or footprint in the local community. For investors who have a place-based approach to investing, it is understood that every place and its challenges are distinct, and as such, the solution needs to be tailored to the place and its unique attributes and complex dynamics.
While simultaneously considering traditional credit factors and bond structure such as maturity and call features, we consider socioeconomic and environmental attributes of the bond issuer and ultimately investing the proceeds into the local community. By matching a challenge with a solution, we can support the strengthening of credit quality–such as investing in stormwater management system upgrades in a city that is prone to flooding. Furthermore, we are able to target communities with greater relative need while managing a portfolio’s credit quality because of some unique attributes of the municipal market. While the credit quality of a municipal bond issuer is affected by the respective wealth of the tax base, especially for general obligation bonds, the prudent management of budgetary matters and overall governance of an issuer also influence credit quality; therefore, weaker socioeconomic factors can be mitigated by good management. In some instances, the socioeconomic characteristics of a particular place may be decoupled from the credit risk of a municipal bond. For instance, for project-based bond issuances, the cash flows of a particular project and the positioning in the capital stack are central to the credit risk and more akin to asset-backed financing. There are also guarantee programs that are unique to the municipal market–such as Government-Sponsored Enterprise (GSE) guarantees for affordable housing related bonds and state guarantee programs to support local school districts allowing them to benefit from state credit ratings, such as the Texas Permanent School Fund.
Engagement as a Tool to Influence Change
Investors in the public markets can engage with issuers on a range of environmental, social, and governance issues and encourage issuers to change policies or practices. As investors, we can signal that environmental, social, and governance considerations matter by incorporating them into our investment criteria and process, but we can go a step further in our role as an investor and engage with issuers to help influence outcomes. At a minimum, we require issuers to provide an appropriate level of disclosure that enables our research team to analyze the issuer’s capital plans, budgetary policy, governance, and management of material social and environmental issues. Municipal analysts engage with issuers; the most common reason is on the topic of transparency and disclosure, as disclosure in the municipal market is inconsistent. In addition, when a project goes awry for a bond in our portfolio, we engage with the issuer to help identify and work toward a solution, to secure the stability of cash flows but to also lead to better social and environmental outcomes. This is especially the case with high yield municipal issuances.
As investors, we can signal that environmental, social, and governance considerations matter by incorporating them into our investment criteria and process, but we can go a step further in our role as an investor and engage with issuers to influence outcomes.
Past engagements include dialogue with a distressed charter school, nonprofit entity, and a clean water project. The distressed charter school example is one that we are particularly proud of. A charter was up for renewal at a local school district, and before the negotiation period began, a new superintendent started and was tasked with auditing the charter school’s finances. The superintendent voiced some concerns regarding transparency of fund allocations and compliance with special education mandates. The relationship between the superintendent and the charter school’s executive director quickly soured, and bondholders were notified that the charter was likely to be revoked, which would likely close the school. As one of the three bondholders, we took the lead to mediate the situation. Both sides would suffer losses if the charter school were to close. The charter school’s students would be relocated to the already over-capacity public school mid-year, and our cash flows from the charter school bonds would be in jeopardy. Ultimately, after a long series of discussions and negotiation, the charter was renewed primarily due to Neuberger Berman’s engagement on the issue.
Municipal Bonds as Part of a Total Portfolio Impact Solution
At Neuberger Berman, how we apply this framework into our investing processes is crucial to our Municipal Impact strategy. Our fundamental, bottom-up investment approach naturally lends itself to incorporating impact pillars as additional factors to consider by each seasoned investment professional. Assessing the three pillars of issuer, use of proceeds, and place are critical to understanding the impact potential of a municipal bond. The application of our impact methodology is independently reviewed by the ESG & Impact Investing Team on a regular basis. In addition to these important considerations, active engagement enhances our ability to deliver investment results to achieve our investors’ financial goals and also augments our ability to influence positive outcomes in line with our investors’ impact goals.
Given the fragmented nature of the municipal market and a buyer base that is typically “buy and hold”, sourcing bonds is critical to our approach of building well-diversified portfolios. With $10 billion in assets under management and relationships with over 100 broker dealers, the Neuberger Berman Municipal team experiences broad market access and robust deal flow. For investors who have a total portfolio approach to the impact of their investments, investing in municipal bonds is a way to incorporate impact into fixed income allocations. The Neuberger Berman Municipal Impact strategy allows investors to achieve their typical financial objectives for investing in municipal bonds–capital preservation, income generation, and tax efficiency–while also delivering on their impact objectives to support sustainable communities and address some of the most pressing social and environmental challenges.