ESG Integration: Chasing Trends or Managing Risk?

March 23, 2021
In 2020, sustainable and ESG funds took in a record $51 billion of capital, continuing a strong trend of asset growth. We at BBH have not rushed to launch a specific ESG product, but we appreciate the role that ESG factors played in helping protect client capital during last year's turmoil. To learn more about how our ESG integration helps us manage risk, please read on.

We have never aspired to be trendsetters. Our investment strategy is rooted in old-fashioned values – protecting client capital and generating strong risk-adjusted returns. We do this through owning a limited number of durable credits[1] that provide attractive yields. Several years ago, we noted the rise of Environmental, Social and Governance (ESG) investing in the public finance markets. Around the same time, we began receiving a growing number of client and prospect questions on the subject.

This prompted us to explain our approach to ESG integration in a 2019 Strategy Insight, titled “Municipal Bonds and ESG – A New Acronym, With the Same Old Risks”. In it, we described how we go beyond simply evaluating an issuer’s behavior with regard to ESG to assess whether there are outside ESG factors which could impact our bond’s pledged revenues. For an ESG integration approach to be impactful, we believe an investor needs to look beyond the surface labels such as “green” or “social” bonds. Instead, ESG is an important lens to screen for potential unmitigated risk factors.


ESG -related risks to our pledged revenues, from a Traditional and BBH ESG Approach.

In order to effectively protect capital, we must ensure that our credits remain money good through a wide variety of economic and political circumstances… and what better test than 2020? Never before have we experienced a Great Depression-like economic contraction coupled with a public health crisis, social unrest, and political disorder – all at the same time.

Amidst this backdrop, concepts such as sustainability and social consciousness have been resonating with investors more than ever. Much of the emphasis prior to COVID-19 was on environmental concerns like clean energy and emissions targets. Governance issues such as improving transparency were another major consideration as investors demanded more thorough and timely disclosures.

Now we are seeing a pivot towards social concerns. Core to the social pillar of ESG is the sustainable provision of services, what we call “service solvency”. A municipal government or enterprise exists to provide core essential public services, such as public safety, health, and education. To do so, it must hire and retain workers at a fair wage. And it must do all these things, as well as service its financial obligations, while preserving affordability for its community. But what does that look like in the face of COVID-19?

The pandemic’s impact is widespread, and beyond its tragic human cost, it is wreaking financial havoc throughout the nation. Issuers from all corners of the municipal market face challenges, but the resources and flexibility for effectively handling them vary greatly. While we never explicitly considered a global pandemic when underwriting a credit prior to last spring, we always used conservative standards and punitive “what-if” scenarios. Remember, capital preservation is job number one for us. This left us prepared, holding a portfolio that was well-positioned to weather the proverbial storm.

For a bond to be well-positioned to withstand an unprecedented event such as the coronavirus, the taxes or revenues backing it should exhibit four key characteristics: they should be broadly defined, less cyclical, geographically diverse, and derived from an esential purpose or project. State governments received significant negative press throughout much of 2020. While all states maintain a public health infrastructure, none were adequately equipped to handle a deadly pandemic. States were required to develop policies to manage new and unprecedented social considerations in fighting the virus, such as establishing testing and tracing protocols and quarantine rules. Other tough policy decisions impacted schooling and the parameters by which “non-essential” businesses could operate, if at all.

Despite these challenges, we believe the negative headlines were largely undeserved from a credit perspective. We are pleased that estimates of revenue shortfalls have steadily declined since last spring and the money states are slated to receive from the American Rescue Plan Act will provide welcome replenishment Still, state governments will face tough choices balancing the funding of essential services while the need to balance their budgets. They have numerous levers to pull, including spending down reserves in their rainy-day funds, borrowing, or raising taxes if necessary. Furloughs, layoffs, education funding cuts, and capital spending cuts or delays are all commonly used to lower expenses, albeit with social impact.

State general obligation (GO) bonds provide an effective contrast to credits that are less resilient to a major disruption. These credits are typically backed by tax bases or revenue streams that are more narrowly defined, cyclical, geographically concentrated, or derived from non-essential projects, which heightens their sensitivity to social risk factors. Examples include dedicated tax bonds backed by hotel taxes which have faced dramatic declines in tourism, or local sales tax bonds with a concentrated economic base. These bonds may have been issued for non-essential purposes such as sports arenas or shopping malls. This lack of essentiality presents a threat to both stakeholders, who may face higher taxes, and bondholders, who could face an issuer with less willingness to pay if times get tough.

More durable tax bases or revenue streams: Less durable tax bases or revenue streams:
Broadly defined Narrowly defined
Less cyclical More cyclical
Geographically diverse Geographically concentrated
Derived from essential purpose or project Derived from non-essential purpose or propose or project

The social pillar of ESG envelops larger issues such as racial injustice and income inequality. These issues touch many municipal credits. We have long been owners of State Housing Finance Authority (HFA) bonds. State HFAs use conservative underwriting standards and largely emerged from the Global Financial Crisis (GFC) unscathed. The programs in which we invest feature a large presence of federal mortgage insurance and overcollateralization, making them remote from impairment despite last year’s major economic fluctuations. And from an ESG standpoint, these bonds are even better. The mission of state HFAs is to provide safe and affordable housing for qualified low- to moderate-income first-time home buyers. Facilitating homeownership will not solve all of society’s complex issues, but for many Americans, it is a step in the right direction.

Although we believe the social risks of 2020 still persist, market valuations appear to disagree. From our viewpoint, municipal credit valuations have already incorporated a successful vaccine rollout. While we are only in the early stages of the vaccination program, case counts are still elevated, and new mutations remain troublesome. When markets writhed in volatility last spring, we actively invested in numerous strong credits at very attractive yields. In contrast, we find today’s historically narrow credit spreads difficult to justify. Managing risk extends beyond just our credit criteria – we also want to make sure we are properly compensated for any bond we purchase and, right now, much of the market is too expensive.

BBH has not prospered for over 200 years by chasing the latest trends. It is one reason why we have not rushed to launch any ESG-branded strategies. But we are a firm that cares deeply about managing risk. That is why we integrated ESG into our research process many years ago, and in a more thorough manner than just analyzing how an issuer behaves. Evaluating the risks to the pledged revenues that back our bonds is foundational to our credit work. Looking deeper, remaining particular about valuations, and staying patient served us well last year. It has also left our portfolios prepared to face the ongoing uncertainties of the pandemic. COVID-19 and its after-effects will likely be felt for many years. While we still do not know what the new normal will look like, we will hope for the best, but prepare for the worst.

1 Obligations such as bonds, notes, loans, leases, and other forms of indebtedness, except for cash and cash equivalents, issued by obligors other than the U.S. Government and its agencies, totaled at the level of the ultimate obligor or guarantor of the Obligation.

Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.

Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.

RISKS

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.

Brown Brothers Harriman & Co. ("BBH") may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2021. All rights reserved. IM-09287-2021-03-23

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