Municipal Bonds Can Naturally Meet ESG Goals

Q. What asset class naturally offers ESG investment opportunities, relatively low risk, public market liquidity, tax benefits and a better return than U.S. Treasuries?

Hint:  The first of its kind was issued in 1812. Find the answer below.

ESG investing, also known as sustainable investing, is becoming increasingly important in the marketplace. This investment approach combines environmental, social and governance criteria with financial metrics. Investing according to ESG principles doesn’t have to mean giving up returns and can often reduce risk. That matters, given the increasing investor interest.

A 2019 survey in the U.S. found that more than 85% of individual investors and 95% of Millennials (the population group born 1981–1996) expressed interest in sustainable investing. These percentages were each up about 10% over the 2015 poll results. In addition, the 2019 survey found 65% of respondents wanted more sustainable investment product choices.¹ For these ESG investors, municipal bonds can represent a core holding.

Municipal Bonds and ESG Investors Seem Made for Each Other

Muni bonds are a natural asset class for ESG investors for several reasons:

• Munis often finance projects devoted to health care, education, environmental enhancements and infrastructure facilities intended to improve communities and the lives in them.
• The social and environmental outcomes from muni bond financings are often measurable and material, a win for many ESG investors seeking impact.
• Munis can benefit taxpayers through tax exemptions and governments through reduced financing costs.

“Green” muni bonds² typically raise funds for renewable power, clean water, waste management and energy-efficiency projects, including buildings, but they represent only about 2% of all muni issuance. While most muni bonds are not officially designated “green,” many are issued with intended outcomes that align with ESG principles. In fact, most muni bond issue proceeds are used to finance social and environmental needs.

Use of Proceeds from Municipal Bonds (Issued 2009–2018)

Sources: MSRB, Thomson Reuters, 2018

Challenges of Integrating ESG Research with Financial Analysis

Integrating ESG research with rigorous financial analysis can help limit performance risk, but there is a lot to scrutinize. Considerations include planned use of the muni bond issue proceeds, project location, climate change impact and the sustainability of the project.

Moreover, with 50 states and many municipalities issuing bonds under different laws and statutes—all potentially influencing investment outcomes—muni bond analysis can be complex. Risks and opportunities can differ by issue as well as issuer, state and municipality. A due diligence checklist can help ensure that investors get the ESG outcomes they seek.

Indispensable Role of the Municipal Bond Portfolio Manager in ESG Analysis

Rating agencies are only beginning to consider ESG criteria in their evaluations, but some portfolio managers of muni bond funds have been actively factoring in ESG analysis for many years. Depending on investors’ specific ESG concerns, active portfolio managers can offer customized muni SMAs with exposure to mission-driven themes, such as faith-based, mental health or carbon mitigation.

Sustainable investing can be a powerful tool for change. Municipal bonds, by their very nature, should play a major role in ESG investment portfolios. However, as universal ESG rating standards are not available in this asset class, investors may choose to rely on the expertise of proven muni bond portfolio managers to find the best opportunities.

Answer: Municipal bonds.³ The first recorded municipal bond was a general obligation bond issued by the City of New York for a canal in 1812.