This article – ESG Integration Into Municipal Credit Analysis – is the sixth of an eight-article series from the CFA Institute that recaps their ongoing research into the application of Environmental, Social and Governance standards to investment analysis and selection.
The CFA institute is a global think tank with more than 150,000 CFA charterholders globally. The Chartered Financial Analyst® designation is the most respected and recognized investment management designation in the world. The author of this article, Matt Orsagh, CFA, CIPM, is one of a team of analysts studying the practical and policy implications of deploying ESG standards around the world.
by Matt Orsagh, CFA, CIPM
The sub-sovereign bond market is composed of any level of government below the national or central government. This includes relevant bodies from regions, provinces, states, or municipalities that issue bonds. The US sub-sovereign market consists of mainly munipical bonds. At approximately $3.85 trillion in size, according to The Securities Industry and Financial Markets Association (SIFMA), the US municipal bond market represents most of the global municipal bond market.
ESG factors have long been used to determine a bond’s credit quality in the municipal space and to identify financial risks in a municipality’s operations or for a particular public project. The quality of the issuer’s governance and management practices are typically a constant in credit analysis for any municipal bond issuer. Practitioners look at overall transparency and reporting, corruption levels, sound budgetary practices, and responsible use of debt (e.g., close monitoring of long-term pension liabilities and principal maturities, implementation of affordable capital plans, strong financial controls). They might view a management team that provides robust disclosure in a positive light relative to its peers.
Sound governance can also be assessed for those issuers who think beyond immediate budgetary needs and make investments intended to strengthen the economic success and social inclusiveness of their communities, as inclusive communities should exhibit stronger creditworthiness and lower risk for practitioners. As such, municipal borrowings that pro- vide social benefits may offset the negative impact of temporarily weak finances.
For both general obligation and revenue bonds, chronic social and environmental problems can affect the issuer’s ability to raise revenues from taxes or other types of income. For example, low high school graduation rates, high violent crime rates, lack of affordable housing stock in the community, and high unemployment rates could result in long-term credit stress. Environmental factors such as the region’s air quality and associated health risks for its constituents, the quality of public infrastructure such as wastewater treatment plants, or the long-term impact of climate change can all pose potential risks to macro factors that may affect an issuer’s ability to repay its debt. Overall, some practitioners find that the more a municipality’s purpose or public project aligns with the environ- mental and social needs of its constituents, the more likely it is that it will repay the bond.
For project revenue bonds, practitioners may also integrate additional ESG factors based on the underlying use of the proceeds (e.g., giving more weight to environmental factors for electric and water utilities, to social factors for education, and to healthcare issuers).
Because of the limited coverage of this asset class by third-party research providers, practitioners often use discretion to determine materiality and integrate ESG factors through the fundamental research process. Practitioners in the municipal market may depend more strongly on credit ratings agency research, and may integrate ESG factors by expanding their view to include environmental indicators that capture local and regional resource challenges.
Matt Orsagh, CFA, CIPM, is a director of capital markets policy at CFA Institute where he focuses on corporate governance issues. He was named one of the 2008 “Rising Stars of Corporate Governance” by the Millstein Center for Corporate Governance and Performance at the Yale School of Management.