A Guide to ESG Strategies for Municipal Bond Investors

Municipal bond investors increasingly want to apply environmental, social and governance (ESG) considerations to their portfolios. But, given a broad spectrum of approaches, knowing where to start can be challenging.

We’ve identified three key strategies for incorporating ESG into muni investing, each with a distinct approach that appeals to different investor objectives. Below, we provide an investor guide to ESG integration, screening and impact investing.

Integration: Measuring ESG Across Muni Portfolios

ESG integration is the process of incorporating ESG factors across a portfolio to gauge its risk and return potential more accurately. It’s a familiar theme in equity and taxable bond portfolios, but still evolving in the muni market, where issuers outnumber US investment-grade corporate issuers by 4 to 1.

Why do it? Because ESG factors can—and often do—directly impact an issuer’s bottom line. In fact, ESG-related breaches can lead to downgrades, lawsuits and looming financial burdens. Conversely, issuers that score high on ESG measures may represent exceptional value, since relative strengths and weaknesses may not be apparent without an ESG lens.

Managers who can discern among ESG laggards and leaders will have a leg up on the muni market, which typically doesn’t yet make such distinctions. That makes ESG integration suitable for all muni investors. From short to long duration, from national to state-specific and from high grade to high yield, every muni strategy can benefit from this additional scrutiny.

To root out potential laggards, managers must ask tough questions. Is that city’s drinking water safe (E)? What’s the town’s high school graduation rate (S)? How intense is local government’s political gridlock (G)? We favor a scoring model, applied consistently across issuers, that rates attributes on a scale of 1 to 10. These metrics boil down to a final ESG score, which helps us discern among undervalued bond issues and potential investments whose outsized ESG risks warrant more yield (Display).

 

Screening: Customizing According to Investor Preferences

Some muni investors may want to apply ESG screening to avoid specific issuers based on personal considerations and values. For instance, some avoid utilities that rely heavily on coal for power generation or healthcare systems with poor reputations; others may prioritize air quality, income equity or women’s empowerment. A muni screening strategy can customize portfolios based on what investors care about most (Display).

 

As with integration, muni ESG screening starts with the broad $4 trillion muni bond universe. But after applying ESG screens, managers can further eliminate lower-scoring issuers within the investor’s selected themes.

Given the muni market’s vastness, this kind of screening isn’t easy. Few managers have made the big technological commitment required to gather the data and to screen portfolios for the client’s desired ESG considerations without degrading other key portfolio factors such as quality and yield (Display). But for a bond manager who is properly equipped, screening and best-of-breed approaches can be another notch in the customization toolbelt.

 

Impact: Improving Outcomes for Underserved Communities

Impact investing intentionally supports social and environmental progress by focusing on programs or projects with specific purpose and results in mind. In this vein, muni impact investing can deliver positive improvements to historically underserved communities. That’s why it’s a natural fit for muni investors who want to make a measurable difference in addressing socio-economic inequities.

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

Improved access to education and healthcare are frequent focus areas too. For example, Gallaudet University, the world’s only liberal arts college devoted to deaf, hard-of-hearing and deafblind students, issued a $40 million bond to fund facility improvements to further optimize its educational environment. Not far away, the West Virginia University Health System’s bond will help pay for expanded outreach to the state’s more vulnerable and at-risk residents, like teens addicted to opioids or older adults living in remote mountain and rural areas.

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

 

Choosing a Muni ESG Approach Hinges on Investor Goals

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 vast, 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 study all their options across the spectrum to know which strategy best aligns with what they hope to achieve.