07.25.18

Municipal Bonds: A Natural Fit for ESG Investing

Dennis Johnson
TIAA has a proud legacy of serving clients who are making a difference in the lives of others. With this in mind, it’s only natural that some TIAA clients should express interest in aligning their investments with their desire to have a positive impact.
 
Such client feedback has served as one of many catalysts behind a growing investment trend that goes beyond the traditional focus on financial and managerial assessments in selecting investments. This approach, along with those foundational components, also includes an evaluation of an issuer’s environmental, social and governance practices, and is thus known as “ESG” investing.
 
When considering the broad criteria for such investments, it becomes apparent that as an asset class, municipal bonds tend to fit well within an ESG framework. The projects and initiatives financed by municipal bonds are frequently centered on providing a social or environmental benefit to the local community. The regular funding needs of education, affordable housing, healthcare, mass transit and infrastructure are all served by the municipal market, which provides access to lower cost, tax-exempt financing for such projects. For suitable clients in TIAA Private Asset Management placed into a Tax Exempt Fixed Income Strategy, investments include municipal bonds in the preceding areas, along with additional ESG-oriented sectors including clean water, renewable energy and community development.
 
Municipal bond issuers are also taking notice of developments in ESG investing as they direct greater attention and resources to the objectives of sustainability and climate change resiliency. By staying attuned to these and other evolving ESG themes, municipalities can help protect tax revenues while ensuring that these resources are deployed in a thoughtful and responsible manner. From our perspective, municipal bond issuers that embrace ESG principles can potentially achieve higher credit quality and lower default rates in the long run relative to those that disregard them.
 
A discussion of an ESG investment focus within municipal bonds often includes the topic of “green bonds” which are issued—at least in part—to fund environmentally friendly projects or activities. While green bonds are structurally similar to conventional bonds, they are often differentiated by the specific use of certain proceeds for an environment purpose. Green bonds exist in both the taxable and municipal bond markets. Although issuance of green bonds reached $146 billion in 20171 and is projected to expand, some practical considerations to accessing these bonds deserve mention. First, U.S. issuance of green bonds remains a small fraction of overall issuance (less than 20% of 2017’s new issue supply came from North America2), making green bonds both somewhat rare and potentially more expensive than other similar quality bonds. In fact, a portfolio consisting of only green bonds would likely have difficulty maintaining proper sector and issuer diversification given the limited depth of the market. Second, as there is no single established standard in the United States for what qualifies as a green bond, issuers may cite differing sources and criteria, some of which may be self-established and difficult to verify. Accordingly, many municipal bonds that positively contribute to an environmental or social goal do not actively seek out and implement the green bond label and would be unnecessarily excluded from any strategy that seeks to purchase only bonds labelled as green.
 
As an example, Southern California Public Power Agency issued bonds to help finance its purchase of a portion of a wind energy farm. This initiative will provide more than 1.5 million customers in the Los Angeles area with clean, renewable and carbon-neutral energy. While these bonds were not designated green by the issuer, they fit within the ESG framework because they insulate the issuer from increasingly harsher state pollution regulations while increasing the power agency’s available energy fuel sources.
 
A disciplined credit analysis process is the cornerstone of municipal bond portfolio management, and it represents an integral part of the value proposition for clients. Key influences affecting an issuer’s credit quality are considered, such as: the economy; tax base; debt burden; financial operations; project essentiality; and management. TIAA's Fixed Income Investment Management Group incorporates ESG considerations into the overall assessment of each bond’s creditworthiness to help identify lower risk investments. Additionally, diversification across a spectrum of ESG themes helps to minimize risks while achieving the greatest impact, which further enhances the value proposition.
 
Given the factors discussed above, certain municipal bonds are a natural fit for clients who express a desire to invest in a manner that promotes social and environmental welfare. Since investment grade municipal bonds have historically exhibited high levels of creditworthiness and stability, clients invested in TIAA Private Asset Management with a Tax-Exempt Fixed Income Strategy can effectively maintain their desired principles without sacrificing the credit quality and performance of their investments.
1Climate Bond Initiative chart, "Looking for the 'Green' in Green Bonds," CreditSights, March 13, 2018.
 
2Dealogic and Bloomberg (as cited in "Looking for the 'Green' in Green Bonds," CreditSights, March 13, 2018.
 
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