Political strategies

A Guide to ESG Strategies for Municipal Bond Investors

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By Erin Bigley, CFA; Marc Uy; Gavin Romm, CFA; and Larry Bellinger, CFA

Municipal bond investors increasingly want to apply environmental, social and governance (ESG) considerations to their portfolios. But, given the wide range of approaches, it can be difficult to know where to start.

We have identified three key strategies for integrating ESG into municipal investing, each with a distinct approach that appeals to different investor goals. Below, we provide an investor’s guide to ESG integration, screening and impact investing.

Integration: Measuring ESG in Muni portfolios

ESG integration is the process of incorporating ESG factors into a portfolio to more accurately assess its risk and return potential. It’s a familiar theme in taxable stock and bond portfolios, but one that continues to evolve in the muni market, where issuers outnumber US investment grade issuers 4 to 1.

Why do it? Because ESG factors can – and often do – have a direct impact on an issuer’s bottom line. In fact, ESG-related violations can lead to impending downgrades, lawsuits, and financial charges. Conversely, issuers that score high on ESG metrics may represent exceptional value, as relative strengths and weaknesses may not be apparent without an ESG lens.

Managers who can discern among ESG laggards and leaders will have an edge over the muni market, which typically does not yet make such distinctions. This makes ESG integration suitable for all municipal investors. From short to long-term, national to state-specific, and high-end to high-yield, every city strategy can benefit from this additional scrutiny.

To weed out potential stragglers, managers need to ask tough questions. Is the drinking water in this city safe (E)? What is the city’s high school (S) graduation rate? How intense is the local government’s political deadlock (G)? We favor a rating model, applied consistently across issuers, which rates assign on a scale of 1 to 10. These metrics boil down to a final ESG rating, which helps us discern between undervalued bond issues and potential investments whose disproportionate ESG risks justify a higher return (Display).

ESG Integration Compares Munis Metrics

Each muni issuer is scored on things like air quality and poverty rates, all of which feed into a comparable final ESG score.

For illustrative purposes only. As of March 31, 2022 (AllianceBernstein)

Screening: customization to investor preferences

Some wealthy investors may wish to apply ESG screening to avoid specific issuers based on personal considerations and values. For example, some avoid utilities that rely heavily on coal for power generation or disreputable healthcare systems; others may prioritize air quality, income equity or women’s empowerment. A muni screening strategy can customize portfolios based on what investors are most interested in (Display).

Examples of Muni ESG screening, which is more personalized

Weeding out issuers that don't meet investors' expectations can build the best portfolios around their values.

For illustrative purposes only. As of December 31, 2021 (AllianceBernstein)

As with integration, ESG muni screening begins with the vast universe of $4 trillion muni bonds. But after applying ESG filters, managers can further filter out lower-rated issuers in the themes selected by the investor.

Given the vastness of the muni market, this type of screening is not easy. Few managers have done the great technological commitment necessary to collect data and select portfolios based on the client’s desired ESG considerations without degrading other key portfolio factors such as quality and yield (Display). But for a properly equipped bond manager, the selection and best approaches can be another notch in the customization tool belt.

Measuring ESG doesn’t have to be expensive

YTW weighted average (percentage)

Portfolios that weed out low-rated issuers in key themes either lost very little return or performed better.

For illustrative purposes only. YTW: Yield to Worst – a measure of the lowest possible yield for bonds that perform within the terms of their contract without defaulting. Avg. Weighted YTWs are for AA-rated, 5% coupon, non-submersible, uninsured bonds with option-adjusted tenors of 6 to 10 years. As of January 31, 2022 (AllianceBernstein)

Impact: Improve outcomes for underserved communities

Impact investing intentionally supports social and environmental progress by focusing on programs or projects with a specific purpose and results. In this vein, municipal impact investing can bring positive improvements to historically underserved communities. That’s why it’s a natural choice for municipal investors who want to make a measurable difference in the fight against socio-economic inequalities.

Municipal impact investing can target many important ESG-related goals, from improving water supplies and public transportation to energy efficiency and economic development. The Buffalo Sewer Authority, for example, issued a $50 million bond to fund green infrastructure and reduce untreated sewage runoff into nearby waterways. Similarly, the City of Oakland’s Bond Measure KK funds targeted investments in roads and other infrastructure in neighborhoods that need it most, as well as affordable housing.

Improving access to education and health care is also a priority area. For example, Gallaudet University, the world’s only liberal arts college dedicated to deaf, hard of hearing and deafblind students, issued a $40 million bond to fund facility upgrades to further optimize its educational environment. Nearby, the West Virginia University Health System Bond will help pay for expanded outreach to the state’s most vulnerable and at-risk residents, like opioid-addicted teens or seniors living in mountainous and remote rural areas.

Results are just as important as intentionality. Impact investors need to measure how proceeds from each bond are used to achieve environmental or social goals, many of which often overlap. The results that tell us whether the project is successful are measured differently depending on the sector or ESG themes (Display).

Tracking Muni’s impact: Success looks different across focus areas

Key performance indicators, such as hospital admissions, graduation rates, and carbon emissions, help track issuer results.

For illustrative purposes only. As of June 30, 2020 (AllianceBernstein)

The choice of a Muni ESG approach depends on the objectives of the investor

As ESG becomes a bigger part of muni investing, it’s important to discern among the many approaches before jumping in. The muni market is large, and muni bonds – as well as issuers – offer varying ESG investment risks and rewards. Muni investors considering how ESG adds value to their portfolios should explore all of their options across the spectrum to find out which strategy best matches what they hope to achieve.

The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions of all of AB’s portfolio management teams. Views are subject to change over time.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.