Independent Thinking®

Impact Investing with Municipal Bonds

By Iain Silverthorne
January 20, 2017

In past issues of Independent Thinking, we have written extensively about private investors’ increasing interest in incorporating their Environmental, Social or Governance, or ESG, preferences into at least part of their equity investing mandates. Can these same ESG preferences be accommodated in allocations to defensive assets without sacrificing return or liquidity? We believe the answer is a resounding yes.
 
Municipal bonds, by their very definition, have the capability to fund programs and infrastructure to serve the public good. Indeed, they must serve the public good to retain their tax-exempt status1. Both state and local governments are increasingly focused on debt issues, to address additions to federal regulations without commensurate federal funding. While these regulatory burdens may ease under the new presidential administration, it is possible that demand from investors anxious to protect the environment and effect social and governance change will grow correspondingly.
 
In the interim, investors have plenty of choice. Capital projects that now meet ESG criteria for municipalities or non-profit organizations include programs as diverse as affordable housing, mass transit, public education, and anti-pollution projects for water, wastewater and public power systems.
 
As the managers of tax-exempt municipal bond portfolios, our investment process for ESG mandates is largely the same as it is for traditional bonds. We want to understand the fundamental credit profile of each qualified issuer and the likelihood that it will pay bondholders on time and in full, based on economic, administrative, financial, and debt factors. In short, we are focused on risk-adjusted returns. We also consider the use of bond proceeds to fund programs and infrastructure projects to serve the public good and, in doing so, meet each client’s specific goals in the context of his or her appetite for risk.
 
Investors in Oregon debt, for example, need to know just how the Portland Water Bureau supports its claim to fame, “From forest to faucet, we deliver the best drinking water in the world.” It does so through a continued willingness to regularly increase user rates to support debt and operations (although rates remain in line with its regional peers). The city is on track to meet its 2020 Environmental Protection Agency water storage facilities compliance deadline and to accommodate its expanding economy while maintaining its Aaa-rating
 
Other recent examples of this virtuous circle – in which ESG demands both economic and social returns – include bonds issues designed to expand mass transit options, provide affordable housing options to lower the homelessness rate, and improve public school infrastructure, notably in energy efficiency, to create long-term financial and environmental benefits. It’s worth mentioning that all projects of this type also support the local construction trade and expand other employment opportunities.
 
It’s also important to note that not all environmentally or socially beneficial use of proceeds can be considered an acceptable bond investment if the ultimate security for the debt runs counter to an investor’s ESG goals. For example, tobacco bonds issued by a state to fund various education projects but ultimately secured by tobacco company payments from the Master Settlement Agreement would be excluded from our ESG framework.
 
However, most of the credit-worthy issuers that we follow in the municipal bond market qualify for our ESG tax-exempt investing framework (see the box below). Interested investors may find that they can express their values without making substantial changes to their portfolios. For taxable investors, these municipal bonds can play a critical asset allocation role in providing tax-efficient income, along with the diversification and risk reduction benefits traditionally associated with defensive assets.
 
Iain Silverthorne is a Partner and Wealth & Fiduciary Advisor at Evercore Wealth Management. He can be contacted at [email protected].
 

Muni Bonds and ESG: Plenty of Options

By Howard Cure

Some municipal sectors naturally lend themselves to bond issuance and social impact investing. While many of the goals and requirements are driven by Washington legislation and departmental regulations, state and local governments are inevitably responsible for implementation. Under the new Trump administration, there are expected questions about changes in all sorts of federal regulations that have driven many of these socially responsible investment initiatives and the amount of federal monies available to address them. Initial proposals from the Trump team have also indicated a growing interest in using the private sector; specifically, Public-Private Partnerships, or P3s, to address the nation’s infrastructure needs. We will address any related investment opportunities in future editions of Independent Thinking.
 
Waterworks, Sanitary Sewer & Drainage Utility Systems: Examples of debt for these essential public health services are utility revenue bonds issued by a city or utility board, retail raw-water service providers such as irrigation districts, and a regional authority that provides primarily retail water and sewer service.
 
Electric and Gas Systems: The strength of a utility’s operational profile and cost competitiveness is rooted in its portfolio of power and fuel supply resources. Successful resource planning, most often accomplished through fuel source diversity, is fundamental to the utility’s future health, given the objective to provide low-cost, safe, and reliable power supply to its customers.
 
The continuing challenge of managing environmental regulations related to clean air and renewable standards underscores the importance of maintaining a variety of power and fuel resources. Public power electric utilities with limited diversification or that are heavily reliant on a single type of generation and fuel source (including coal) are typically subject to generation risk exposure. However, we generally view debt issued to diversify the generation base and mitigate this reliance favorably.
 
State Housing Finance Agencies: HFAs are established by state or local law to provide financing for affordable housing and, as such, play an important role in the housing market. They are generally self-supporting entities, primarily paying bond debt service and expenses from revenue generated by the loans they finance. Interestingly, some HFAs are also involved in other activities, such as issuing bonds for economic development, infrastructure, or privatized military housing, and administering housing programs funded by the state or federal government.
 
Not-for-Profit Healthcare: Hospitals face the challenge of balancing spending to support the mission, clinical services and capital reinvestment with sustaining long-term financial viability. Concentration of government revenue sources adds pressure to operating performance. The size and breadth, or scope of operations, of a hospital is a general gauge of its significance in its region. A greater scope of operations typically indicates stability, diversification of product lines and revenue sources, and the ability to take advantage of economies of scale and generate sufficient cash flow for capital investment. We rarely invest in the debt of hospitals where the institution does not have a significant market share.
 
Mass Transit Enterprises: The mass transit sector covers several modes of transportation, including bus, rail, light rail, and ferry. This sector enjoys unique strengths, including high essentiality, enduring demand through economic cycles, little or no competition, predictable revenues, and relatively low carbon footprints for users. These systems are capital intensive, including pressure to fund capital projects and high maintenance costs from available system revenues after the payment of debt and operating expenses.
 
Community College Revenue and Tax Backed Bonds: Community colleges play a vital role in U.S. higher education, serving approximately 40% of all undergraduate students in the country. As access-oriented, low-cost institutions, they are often an entry point to higher education.
 
Green Bonds: Green Bonds, as a subset of Socially Responsible Fixed Income Investing, or SRFI, allow us to expand the number of sectors included in our ESG enterprise universe. Besides sectors that lend themselves to SRFI, such as mass transit, public housing, and community colleges, bonds with proceeds that have beneficial environmental aims can also be part of an ESG investing framework.
 
Moody’s Investors Service has begun issuing separate Green Bond Assessments, or GBA, to help investors determine if Green Bond proceeds are being used to achieve positive environmental outcomes. To date, Green Bonds are either GB1 or GB2, at the top of a Moody’s five-point scale. Issuance estimates for Green Bonds in the municipal markets in 2016 are between $6.3 and $7.2 billion, a meaningful step up from $4.1 billion in 2015 and $2.4 billion in 2014.1

Howard Cure is the Director of Municipal Bond Research at Evercore Wealth Management. He can be contacted at [email protected].

1 S&P Global Ratings: What’s Next for U.S. Municipal Green Bonds

1 Internal Revenue Service Publication 4079, “Tax-Exempt Governmental Bonds”

Close