The ‘Wild West of labelling’: In search of impact in the US muni bond market

Traditionally viewed as staid and boring, investors are increasingly looking at the muni market as a source of sustainable asset – but will the ESG backlash strike a crippling blow?

“I consider the US municipal securities market to be one of the original ESG investments,” says Mark Kim, CEO of market regulator the Municipal Securities Rulemaking Board (MSRB).

The $4 trillion market is used by US municipalities to raise funds for everything from schools to museums. It is a major source of ESG-labelled bonds, and is one of the largest suppliers of green bonds which allow allocation to resilience and adaptation investments.

There are strong opportunities for impact across “almost every sector” in the municipal bond market, says Amy Hauter, head of sustainable fixed income investing at Brown Advisory.

Affordability and equitable access are strong themes in $121 billion manager’s selection process.

With hospitals, for instance, it looks for institutions focused on affordable access to healthcare, alongside other factors. Housing offers “compelling” opportunities when looking at affordability, says Hauter, while education is “intriguing” in terms of equitable access.

Eric Glass, former senior portfolio manager at AllianceBernstein, agrees that municipal bonds are “the original impact market”. “If you’re looking at it from an impact perspective then you can look out of your window and say, ‘Hey I built that school where 80 to 90 percent of students receive free school meals’.”

He adds: “So many folks are so interested in private equity and venture capital [for impact] but there’s this asset class that’s right in front of their noses that’s been there for decades.”

Perception may be part of the problem. As Glass notes, municipal bonds have often been dismissed as a “staid and boring” asset class. “You have it as ballast and offset to your equity volatility.”

At the same time, he cautions against assumptions about inherent sustainability. “There’s this overarching assumption that anything in the municipal market must be either environmentally or socially beneficial,” he says. “I’m not necessarily saying I disagree with that, but just to state that on its face in a conclusory kind of way is not enough for me.”

Hauter agrees: “A lot of folks think there’s this inherent sustainability lens to all municipal sectors, because municipal bonds mostly have to fund something for a public good and most of them are funding essential services.

“While they are very aligned with sustainable objectives, that doesn’t necessarily mean that every single issuer in every single sector is sustainable.”

Sector specifics

As Hauter notes, some sectors – such as public power focused on renewables, water and sewer utilities, hospitals and educations – are more obviously aligned with sustainability objectives. At the same time, she sees opportunities for impact in more unusual sectors.

While admitting that airports can be controversial, she says some locations are “dedicated to sustainability”. As examples, she points to green bonds issued by Portland Airport, and to Dallas Fort Worth, which claims to be the first carbon-neutral airport in the US.

One area that Brown Advisory has steered clear of is prisons. Hauter says the firm “just doesn’t feel comfortable” investing in the sector from an ESG perspective, citing governance issues around private prisons.

For Glass, however, the prison sector is not entirely uninvestable.

In 2018, AllianceBernstein provided funding via municipal bonds to a project in New Jersey to enable the state to shut down a large older detention facility for juveniles and open three smaller, state-of-the-art facilities. These were to be located along mass transportation lines, allowing families easier access, and could easily be repurposed for economic development if the state managed to cut the number of young people being sent to prison.

Glass, who left AllianceBernstein to be able to take a stronger campaigning stance, is planning to set up his own impact investment firm. “On some level I became a self-appointed guardian of the municipal market as it related to the prison-industrial complex in the US,” he says.

For him, the municipal market is key to the fight for equitable justice, as it “has really been the source of all funding at the state and local level for police, for jails, for prisons, for detention centres”. He is involved in campaigns to “take the air out of” financing for prisons.

These include pushback against plans to sell a $634 million bond in Wisconsin to fund private prisons in Alabama. Barclays, one of the lead underwriters, pulled out after criticism that it was backtracking on a pledge to no longer provide financing to for-profit prisons.

Over a year later, Alabama itself tried to issue the bonds, but was only able to raise around two-thirds of the targeted volume.

The Wild West of labels

The MSRB, which does not directly regulate issuers but is responsible for broker-dealers and municipal advisers, consulted at the end of 2021 on ESG in the marketplace. Respondents identified a lack of common standards and uniform practices as a major problem in the market.

“The muni market is the most staid, old-fashioned, plain vanilla market you can possibly come across,” says Glass. “It’s the Wild West from a labelling perspective.”

In his own investment evaluations, Glass prefers to carry out his own due diligence both on the use of proceeds and the sustainability credentials of the issuer rather than rely on labels. This occasionally throws up instances which look green but have negative externalities.

One of the worst offenders was an industrial development bond issued to fund a recycling facility for a fibreboard company.

While the specific project was green, concerns were raised about the impact of emissions from the facility on the local community. The bond sparked significant controversy, and came shortly before the MSRB’s consultation.

Hauter has faced a similar problem. “There’s no real regulatory oversight over labelling and we’ve passed on labelled bonds that don’t fit our frameworks,” she says. She also emphasises the importance of investor due diligence in the absence of formal oversight.

The lack of it is partially explained by how the market is structured. Many municipal issuers are very small, some have minimal resources, and deal sizes tend to be smaller, so issuers are unwilling to pay additional costs for external verification.

There is also little if any pricing benefit for green-labelled munis, so issuers are unable to gamble on recouping costs via a greenium.

As Hauter notes, however, disclosure concerns are not an ESG-specific issue. “Muni transparency has always been a challenge,” she says. “Municipal issuers are not used to providing a lot of detail on the use of proceeds in a bond document, let alone around ESG criteria.”

Impact of the backlash

As with any topic in the US which touches on sustainable investment, the issue of the ESG backlash is never far away.

One of the looming threats for the market is legislation in Florida, which among other measures would ban municipal issuers in the state from issuing ESG-labelled bonds and from paying for any second-party opinions, ratings or verification.

In a joint letter released in March, Florida governor Ron DeSantis and 18 other state governors vowed to “eliminate consideration of ESG factors by state and local governments when issuing bonds”.

Lauren Kashmanian, director of portfolio management and responsible investing at $398 billion manager Parametric, says that if states begin banning ESG-labelled bond issuance, this could limit short-term market growth.

She notes, however, that states which have led the issuance of ESG-labelled muni debt and are expected to see the fastest market growth in the coming years – California, New York, Massachusetts and Washington – have yet to propose anti-ESG legislation or sign on to initiatives.

Similarly, Hauter says that, while it is “not unreasonable” to think that other like-minded states may follow Florida, the state has seen very few green bond sales to date, so the impact of the legislation will likely be limited.

She also points to the probability of a surge in sustainable projects over the next year as the Inflation Reduction Act acts as a catalyst for the further development of infrastructure.