Municipal Bonds and ESG – A New Acronym, With the Same Old Risks

September 30, 2019

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.

Traditional ESG approach versus BBH ESG Approach

In our view, these pledged revenues represent penalty payments to help offset medical costs associated with tobacco consumption, a societal good. We are cognizant that as tobacco consumption falls, the penalty payments also decline. In other words, as more people quit smoking, pledged revenues weaken. Hence, it is important that our investments in this sector possess an ample margin of safety. Our Tobacco Settlement bonds must be able to withstand 10% annual declines in tobacco shipments – greater than any single year drop experienced to date. As a result of this requirement, we only invest in a select few tobacco settlement bond programs.

We have long thought of management and governance together. Management teams must take a balanced view of their stakeholders, including bondholders; they must respect covenants; and they must value capital markets access. Possessing the power to create new taxes or raise rates on existing taxes is different from exercising that power. Cities often siphon revenues from operating utilities like water-sewer systems to supplement their budgets instead of raising taxes. As a water-sewer bondholder, understanding the risk and dimensions of such behavior is very important to our credit assessment. Even when evaluating a revenue bond, we need to be aware of the governance practices of its related local government. Long-term planning is also important, as are capital spending plans. Frivolous projects can cause significant financial damage. Several years ago, a major western airport issued bonds to build an adjacent hotel — and an expensive one at that! Typically, airports share the cost of hotel construction, but do not foot the bill themselves. After all, the primary purpose of airports is transportation, not lodging. Needless to say, we passed.

Just because a credit aligns well with ESG factors does not mean it would be an acceptable credit for us. With ESG, there can be too much of a good thing — green does not always mean go. Let’s look at State Housing Finance Authorities (HFAs) as an example. Their primary mission is to provide first-time home financing for low-to-moderate income buyers. Expanding home ownership is a clear positive from an ESG standpoint. However, what if the HFAs expanded downpayment assistance excessively? Over time, the HFAs’ credit quality would likely suffer, not only hurting its credit but also potentially compromising their social mission. Not-for-profit hospitals provide clear societal benefits and all provide some degree of charity care. In fact, unless these hospitals provide adequate charity care, they cannot qualify for tax-exempt bond issuance. However, it is easy to understand that too much charity care would be a credit negative as the hospital’s margins and reserves would take a hit.

When ESG and credit collide from an ESG and Credit Perspective.

Developing a comprehensive understanding of risk is key to our credit research process. We do not offer an ESG-branded municipal bond strategy, but Environmental, Social, and Governance-related issues have long factored into our overall assessment of credit risk. Key to ESG and key to our municipal bond strategy is the concept of durability or sustainability. Value-oriented strategies in bonds enjoy an important advantage over equities — contractual maturity dates. We can always hold our bonds to maturity and earn the yield — we do not have to sell. This strategy breaks down if our credits deteriorate. We strive to make sure this does not happen, whether the risks stem from ESG factors, or not. Our enduring mission is, “safety first.”

Gregory Steier
Managing Director
Head of Tax-Exempt Portfolio Management

Kate Fuller
Vice President
Municipal Analyst

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.


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.


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