Investment informed by environmental, social and governance (ESG) factors has become commonplace on the equities and corporate fixed income landscape. However, it’s less well understood that ESG and so-called impact investing can be successfully applied to municipal bonds. Indeed, what we consider effective markers tied to sustainability are ample, and can provide a rich universe of insights—and important warning signs—for those willing to explore the sector with a research focus.
Broadly speaking, ESG analysis addresses a set of performance risks that arise from factors that have often been overlooked by investors. The concepts are outlined in the U.N.-sponsored Principles for Responsible Investment, which leading portfolio managers including Neuberger Berman have signed, pledging to incorporate ESG into their research and investment processes. ESG-informed managers will consider sustainability along with other more traditional elements in assessing the risk/reward of a given security.
Impact, or sustainable, investing takes things a step further. It means that you not only consider the risk factors associated with ESG, but place particular emphasis on them in your investment process. This can mean exclusion based on screening (e.g., avoiding tobacco, firearms or nuclear power) or, in a more nuanced framework, gauging the overall ESG record of an issuer in relation to effects on its performance and the investor’s social goals. Even then, an impact investor may choose to exclude certain issuers that, regardless of securities pricing, simply don’t meet the investor’s standards.
Combining ESG and Traditional Credit Research
Over time, we have found that ESG concepts and traditional credit research have considerable overlap. When conducting municipal research, managers and analysts typically look at five factors: governance, financial condition, leverage, the legal structure of a bond, and the condition of the economy. Of these, governance and financial condition are typically the most visible in the context of sustainability.
- The “G” in ESG, governance is a critical and, in our view, often predictive, part of credit analysis: Are elected officials and their appointees implementing efficient and apolitical policies and programs, and are budgets structurally balanced?
- Environmental risk (the E) can relate to financial condition. For example, a town that is cited repeatedly for releasing excess raw sewage may be hit with fines and have to issue new bonds to cover the cost of improving the system—increasing its leverage and thus hurting its credit profile.
- Social factors (the S) may fall under economic risks/opportunities, and can have implications for financial results. For example, an ESG framework can help reveal whether zoning, economic development or tax-abatement policies could negatively (or positively) affect the income mix of a given community.
ESG analysis formalizes and reinforces such qualitative assessments, while often requiring portfolio managers to look past optics for deeper understanding.
Minimizing ESG Risks
How do you identify issuers or securities with potentially negative ESG-related impacts that could boomerang on municipal investors? At a basic level, this involves understanding the nature of the various pockets of the municipal bond market and being rigorous in determining the materiality of a given risk.
In the municipal market’s early days, financings were very simple and mostly used for the typical infrastructure needs of state and local governments. Over time, however, the boundaries of law and regulation were stretched, and the municipal market became a source of funding, not only for traditional infrastructure, but also for projects that inordinately benefitted private players or didn’t even serve a public purpose.
You may have heard of the “bridge to nowhere,” which became a symbol of pork-barrel spending in the 2008 presidential election. Although Alaska’s Gravida Island Bridge was federally funded, such money-wasting projects exist at the municipal level as well. Other examples have included economic development bonds for convention centers, and loans or grants to commercial entities for economic development.
Often, such transactions become a drag on governmental credit quality due to the additional leverage. And—of particular importance for impact investors—the public is generally not the real beneficiary of proceeds; rather, that’s the private business receiving a low cost of capital via tax-free bond issuance. In some cases, the municipality guarantees these transactions, thus creating a contingent liability that could potentially hurt taxpayers. In others, nongovernmental uses of proceeds can have a social benefit, for example when an investor-owned electric company issues pollution-control bonds to comply with environmental laws.
Professional sports stadiums may also have a negative impact. Towns and cities are often pressured to help finance new stadiums to avoid the departure of a sports franchise. But at the end of the day, the benefits of the new stadium typically accrue to franchise owners (in the form of more revenues), rather than the community. Developers of Yankee Stadium, for example, built a parking garage on nearby parkland. As it turns out, the bonds issued to build the structure have since become distressed due to underuse. In short, some transactions appear to benefit society, but upon deeper review reveal a misuse of public funds or just poor public policy.
From an issuer perspective, it is sometimes mismanagement or the political process that causes collateral damage.
We have historically been wary of issuance from Illinois, where we’ve observed a tendency for political considerations to supersede the public interest; for example, budget stalemates in 2015 – 17 led to deep underfunding of public education, which could have been avoided through compromise on other line items. California offers a more reassuring picture: Although the state has had its own political issues, we believe it has managed the budget process effectively in recent years, providing extensive services while spending within its means.
For investors who are cognizant of ESG-related factors, such issues will typically be balanced against price. The bonds of a particular municipality or project may provide a generous yield that compensates for the additional risk from a given negative practice. On the other hand, some issues may be poorly understood by markets; ESG-informed investors may be more cautious, and thus likely able to avoid “yield traps.” As mentioned, impact investors may choose to avoid certain issuances altogether.
On the Rise: Climate and Social Risks
Although governance has long been a focus of municipal investors, with increased concern over global warming, environmental risk is becoming more prominent. Rising sea levels and more extreme weather patterns are contributing to coastal flooding, while intense droughts have added to the country’s wildfires, most prominently in California. Such acute physical risks are by nature unpredictable, and we believe municipal analysts must seek to account for them in modeling securities prices. Along these lines, our firm has invested in data systems to calculate weather-related risks and their economic impact. Also relevant are gradual weather effects. For example, one southern community saw its water table fall due to a lack of rainfall, requiring that it import water, adding costs for the town and its homeowners. On a more macro level, frequent droughts can cut into agricultural production, resulting in lower tax revenues in already strained communities.
Social factors are also having more effect on municipalities, and to a degree that many investors may not understand. The social risk we focus on most is income inequality, an issue that has been highlighted during the pandemic (see sidebar). Lower income groups often face more significant health challenges, with potentially significant impacts on local finances. Moreover, if a larger portion of the next generation has less disposable income, their ability to buy housing will likely be compromised. That could affect the real estate market, which in turn could undermine the tax base of bond issuers. Although often beneficial, community development projects can sometimes worsen disparities: Higher rents associated with larger employers may drive out smaller businesses and lower-income workers, which can reduce the appeal of a town or city, and by extension weaken its fiscal outlook.
COVID-19 and Income Inequality
The global pandemic has laid bare the issue of income inequality and the challenges faced by underserved communities, particularly when it comes to health. Lower income areas tend to have populations with pre-existing conditions and weaker public health safeguards. During the recent crisis, these vulnerabilities translated not only into undue suffering, but also sizable costs and budgetary pressures. The rapid development and distribution of vaccines, as well as federal economic stimulus, helped to fend off even more serious consequences; however, the potential for more setbacks—whether in the current crisis or in the future—suggests the need for proactive and creative steps to improve public health across income levels. We believe this requires some degree of federal response, but it will also be a function of local leadership. Issuers that are able to make progress in this area may not only serve their communities, but set the table for more stable credit fundamentals over the long term.
A Unified Process
Despite the common misconception that ESG can be “bolted on” to an investment process, we believe that consideration of environmental, social and governance issues should be integral to the efforts of analysts in the municipal space. Moreover, the risks and opportunities represented by ESG factors are just too significant to leave to primitive screens or quantitative-based rating systems that lack human intervention. The municipal bond universe has more than 55,000 issuers with a wide range of credit fundamentals. In our view, extensive research, a disciplined process and a consistent philosophy, all informed by ESG considerations, should be key advantages in seeking to balance risk and return potential in the sector over time.
Our ‘Three Pillars of Impact’
Impact investing goes beyond considering ESG factors in portfolio management to making them a driving force—both to avoid bad actors and to achieve positive effects on the world at large. When investing for impact, we see three elements as important, both individually and in combination, in determining the potential merits of a given bond or issuer.
1. Issuer Governance: Is the issuer well managed with respect to governance, fiscal sustainability and management of material social and environmental issues?
Examples: Puerto Rico’s fiscal picture was unsustainable for more than a decade; investing at the time would have reinforced practices that ultimately contributed to bankruptcy. In contrast, Pennsylvania has suffered from late budgets, but its political process has become more constructive, for example, allowing for stop-gap funding to support essential programs while seeking to solve broader fiscal issues.
2. Use of Proceeds: Will bond proceeds from a project generate effects on the community and environment that could be essential, significant and positive overall?
Examples: Professional sports arenas tend to benefit private entities, not the public. Innovative classroom programs for the underprivileged and moderate-income housing construction often have a positive impact on the community
Impact Spectrum: Use of Proceeds
Source: Neuberger Berman.
3. Community Needs: Does the location of the project have a higher level of relative need, and thus greater potential to contribute to solutions to social or environmental challenges?
Examples: Wastewater treatment that benefits lower-income communities, and mass transit that opens up economic opportunity, fit into this category. Most issuances tend to benefit either the general populace or more affluent communities, making place considerations relatively challenging to address.