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Fixed-Income Insights

Amid growing demand for environmental, social, and governance investment strategies, many issuers in the municipal bond market may already meet the necessary guidelines.  

(Note: This article is from the forthcoming edition of The Muni Quarterly.)

While environmental, social, and governance (ESG) investment strategies have been more prevalent in the European and U.S. corporate markets, municipal bond investors increasingly are able to identify investments with the potential to not only meet ESG guidelines but also to produce competitive financial returns.

After all, a vast majority of municipal projects already address environmental, social, and community-development concerns. As a result, ESG municipal bond portfolios would not need to be meaningfully different from existing portfolios.

Capital projects that could meet ESG criteria for municipalities or nonprofit organizations range wide, and include programs such as conservation projects for water and wastewater systems, renewable energy for public power systems, public education, non-for-profit hospitals and museums, land conservation, mass transit, and affordable housing. (See Figure 1.) In fact, it might be difficult to find a municipal sector that did not incorporate ESG values in certain projects. Perhaps one example could be tobacco bonds issued by a state and secured by tobacco company payments. In many cases, the proceeds are used to fund various education and social welfare projects, which themselves might be considered to be ESG investments.


Figure 1. Viewing Municipal Bonds Through the Lens of ESG

Source: Lord Abbett.


Integrating ESG Factors into the Investment Process
ESG factors can be integrated into the municipal bond-investment process through credit analysis and portfolio construction. Ideally, the credit analysis and portfolio-management process will identify and populate portfolios with municipal issuers that match the ESG values of the investors.  

Although ESG considerations go beyond the standard measures of bottom-up municipal credit analysis, many of the ESG factors are already considered by municipal credit analysts in their customary review of credits. Incorporating ESG factors into the credit-analysis process has the potential to shed light on potential credit distress. For example, a municipal utility system that does not comply with or prepare for current or future environmental regulations may be exposed to outsized capital costs. Or the financial health of a city can be impaired if it does not provide for adequate affordable housing or suitable funding for education. The ability of a municipal issuer to manage a debt program can be jeopardized by municipalities that are unable to maintain fiscal discipline or proper disclosure practices. Late financial filings and a willingness to kick fiscal issues down the road are standard governance issues that are examined by muni bond analysts.

Being able to incorporate a meaningful ESG strategy doesn’t just include screening out those issuers that follow negative practices. Analysis also can focus on how positive behavior supports credit quality. For example, the consideration of ESG factors enables the analyst to consider how a city’s commitment to enhancing educational programs can result in its schools reporting higher test scores and graduation rates, potentially attracting more residents and businesses, which, ultimately, can increase real estate values, potentially leading to more property tax revenue for localities. In addition, a water system that applies strong water treatment or conservation measures may increase support from regulatory bodies, avoiding potential financial penalties and sizable future capital spending. Instead of just a negative screen, a more comprehensive scoring system could be overlaid onto the existing internal rating system.

One of the challenges of applying ESG factors to municipal portfolios is that the definition of ESG is not always clear. Therefore, ESG factors and criteria are not necessarily being applied uniformly by firms that manage these strategies. In surveying several of existing ESG strategies, we found some firms rely on qualitative factors, while others focus on quantitative, with some looking only at the bond’s use of proceeds. Further, many factors being considered today may not be useful in the future, so it is imperative that the criteria remain fluid.

ESG versus “Green” Bonds
ESG sometimes is confused with investing in green bonds, which are a subset of the sustainable-bond universe. Green bonds are issued by corporate and municipal entities to fund projects that benefit the environment, such as clean water, green infrastructure, and renewable energy. To be deemed a green bond, paying a third party for certification may be required. At this point, some issuers prefer not to pay for this endorsement because there is not a financial incentive to do so—they see no unique yield advantage to the green bonds. It is fair to say, however, that there are many bonds that are issued that might be considered green bonds, but do not seek the certification as such.

Meanwhile, green-bond issuance has increased significantly in recent years, reaching $155.5 billion in 2017, with $250 billion expected by 2018, according to Bloomberg. However, of this amount, municipal bonds represent only $30.3 billion, Bloomberg reports, and the vast majority of all municipal securities that claim to have a positive environmental impact do not carry the green bond designation. Although green bonds can serve as a core component of a municipal ESG portfolio, it is critical to look beyond this relatively small sector of those that are officially designated in order to build diversified portfolios without compromising risk management. The fact that there are limited “regulated verifications,” or standardized reporting for green bonds, has resulted in a wide range of criteria being applied and a perceived lack of investor trust and acceptance. This reinforces the importance of bypassing certain labels and applying fundamental analysis, at both the time of issuance and then through ongoing surveillance.

Further, we expect that continued strong demand for green bonds should result in the creation of widely accepted metrics, and that ESG-focused investors will find more opportunity within the municipal-bond market over time. For the sector to grow, asset managers may need to make investors more aware of the opportunities in the municipal market. In addition to the inherent social principles of ESG-oriented municipal bonds, ESG-focused investors also could potentially benefit from an asset class that has relatively low default rates, high credit ratings, and strong relative value compared to other asset classes.

While Lord Abbett currently does not offer any explicitly ESG investment strategies, we believe there is value for investors in identifying issuers with strong governance practices, for example, and that such factors are increasingly important to investors. We are a signatory to the United Nations-supported Principles for Responsible Investing initiative—an international network of investors collaborating to put the principles into practice. We have taken a measured approach to adapting our investment process to incorporate ESG factors, because we believe as prudent fiduciaries that it is important to take a thoughtful approach and get it right for the long term, as the markets coalesce around how these factors are defined and applied. We are, as always, exploring how our product offerings will evolve, and we continue to seek input from clients about what would suit them best.



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