Over the past decade, investors have increasingly sought portfolios that better reflect their personal values. Environmental, Social, and Governance (ESG) investment strategies arose in response to this demand, first in equities and more recently in bonds. Although investors typically associate ESG with corporate entities, ESG products have spread to other sectors such as municipal bonds. This is logical given that municipals serve as a major funding mechanism for public policy and infrastructure.
Our investment objective for municipal bond clients is to protect capital and generate strong risk-adjusted returns. To achieve this objective, we seek to invest in a limited number of durable credits† that we purchase at attractive yields. In our research process, we assess the strength of each credit’s operating model, management, structure, and transparency. Our analysts must reach unanimity on whether a credit satisfies our investment criteria. Each analyst has veto power and unless they all agree, we pass on the investment. Our research process gives us confidence that our credits will mature on time and intact.
From the standpoint of our municipal bond investing, ESG is more about managing risk than seeking return. Without explicitly labeling them as such, our research process incorporates ESG factors, among many others. We find it interesting that there is no market standard for evaluating ESG and the three factors are often inextricably linked. The traditional ESG approach focuses primarily on the way the obligor behaves. Common issues include carbon emissions (environmental), employee relations (social), or corruption levels (governance). The way the obligor operates is important; however, it is only one component of effective credit risk management.
Remember, job number one for our team is the preservation of capital. Our credits must remain money-good through a wide variety of political or economic circumstances. Consequently, we go beyond the traditional approach of looking at the obligor’s behavior. We ask ourselves, “what impact could Environmental, Social, or Governance factors have on our bond’s pledged revenues?” For example, when thinking about environmental factors related to utilities, there is a big difference between asking, “does this power credit pollute?” and “could this power credit handle a natural disaster?” Today, this is front of mind when assessing power credits in California, where clean energy requirements are rising rapidly, as is wildfire liability risk – adding significant environment-related risk to these credits.
Our credit work examines an entity’s ability to provide core essential public services including health, safety, and education – a common area for social risks. The provision of these services is effectively senior to our bonds. It might surprise the casual observer to learn that Tobacco Settlement bonds help satisfy social criteria. For many years, States have been subject to elevated healthcare costs associated with tobacco consumption. We own bonds backed by revenues from the Tobacco Master Settlement Agreement between States and the major tobacco companies. Because of their association with smoking, some investors view Tobacco Settlement bonds as negative from an ESG perspective.
