How the buy-side has sparked major muni ESG growth

As environmental, social and governance bond issuance grows globally, the buy-side is leading the charge in the municipal securities space, demanding more paper and creating investment vehicles tailored for ESG debt. 

Buy-side participants are also requiring more disclosure from issuers to back up the validity of those investments. They want more data, and more concrete answers to their vast, growing and disparate list of questions.

“The buy-side says, ‘We want disclosure,’ very broadly, and we need to be more prescriptive about what it is we want,” said Andrew Teras, director of municipal research at Breckinridge Capital Advisors.

There has been strong demand from a segment of clients interested in ESG but, Teras noted, it can be challenging since ESG and sustainability mean different things to different clients.

“Some clients come to it from more of an impact approach or some want to invest in education bonds, and then other clients are focused on drought in the West,” he said.

Issuers, meanwhile, need clarity on what exactly investors — and ratings agencies and bond insurers and regulators — want them to provide, but they also expect a pricing benefit for their cooperation.

Government officials hesitate to provide certain levels of detail without fully understanding the potential regulatory repercussions of and the costs associated with doing so.

“Issuers are being asked for new and different kinds of information,” Teras said. “A lot of them want to provide this information, but it's not traditionally been provided.”

Factoring ESG considerations into investment decisions also raises questions among industry professionals about the differences between assessing ESG risk factor disclosures and ESG qualifications for labeled bonds. A distinction between the two needs to be made, many participants say.

Incorporating ESG broadly into the municipal industry remains complex and the opinions on how to — or even whether to — take part vary to a large degree based on the participant’s vantage point. 

And while agreeing on the types of information necessary to tell the muni ESG story is complicated, most participants say ESG is inextricably tied to the municipal bond market and the infrastructure it builds.

ESG growth
Global sustainable bond issuance has soared and will likely top $1.5 trillion this year, up from just $200 billion only four years ago.

May’s total ESG issuance was $3.117 billion per SDC Refinitiv data, and ESG issuance through May 31 stands at $10.789 billion versus $12.905 billion from January to May 2021, similar to the decline in total issuance this year. 

“Although total ESG issuance was down slightly from April to May, it is still well above issuance from any month in Q1 and almost equal to the total issuance for the entire quarter,” a monthly ESG report from Refintiv MMD noted.

Last year’s total ESG issuance hit $42.059 billion. While that figure remains slight compared to the overall muni market — the market saw $475-plus billion in 2021 —  it has grown substantially in recent years. In 2015, $2 billion of green bonds were issued.

Green bond designations continue to comprise the majority of ESG municipal issuance, accounting for $19 billion in par volume or 43.6% of ESG issuance last year, per an IHS Markit 2021 Muni ESG Recap report.

While there are no standard definitions of ESG in the space, various participants are working on systems to provide more ESG data. 

And what matters to those both buying and selling those bonds is how added data availability will affect industry growth. Two-thirds of respondents to a Bond Buyer survey conducted last fall saw ESG as an accelerant for municipal finance and 56% saw it as a catalyst for foreign investor interest in the space.

“Demand in the municipal market is driven primarily by interest rates and tax considerations,” noted Robert Tucker, head of investor relations and communication at Assured Guaranty. “Some investors, however, may view municipal bonds as inherently having environmental or social purposes, such as mass transit, education, healthcare or renewable energy. And an expanding investor focus on ESG considerations could help expand the investor base.”

Indeed, there is growing interest abroad in understanding U.S. investments — munis specifically — and issuers themselves have been targeting foreign investors, including the San Francisco Public Utilities Commission, which listed its taxable debt on the London Stock Exchange. 

Foreign investors, particularly in Europe, have much higher regulatory thresholds to meet on what ESG investments they can make. The international regulatory environment, particularly Basel III, Solvency II and the Sustainability Development Goals adopted by most U.N. member countries, are of the some key reasons behind global investors’ interest.

“While starting from a low base, foreign holdings of muni bonds have increased in recent years, both in absolute terms and as a proportion of the overall muni market, according to Federal Reserve data," said Jasper Cox, investment practices analyst, Fixed Income at the Principles for Responsible Investment. "Given that investors and regulators around the world, including in the EU, are paying close attention to ESG factors, if this trend continues it may help propel these factors up the agenda in the US muni market too.”

With the growing interest in ESG investing, "we anticipate an increased appetite for ESG data,” Tucker said. “In our own business, we have had few direct ESG questions from U.S. muni investors, although the institutions we speak with generally understand that ESG plays a role in our underwriting analysis. In the taxable municipal bond market, European investors are generally under more formal requirements to include ESG criteria in their credit selection process.”

Various players in the muni space have created muni-specific funds dedicated to the growing ESG investor base and other data-centric ESG tools.

​Michael Cohick, director of ETF product marketing at VanEck, said investors are clamoring for ESG in all asset classes, including munis. This demand prompted VanEck to launch its first sustainable municipal bond exchange-traded fund in 2021. While the participation to date has been somewhat slow, the hope is interest will pick up when the market bottoms out.

Others have followed suit, with State Street Global Advisors, sub-advised by Nuveen, launching an actively managed muni ESG ETF in April, as the firms said clients sought more ESG investment opportunities. 

AllianceBernstein partnered with Vestmark, Inc., in January to provide a digital separately managed account platform that allows registered investment advisors to create more bespoke muni portfolios, with ESG among the areas of focus.

Bloomberg LP in December launched a U.S. Municipal Impact Index designed to track municipal bonds categorized under green, social and sustainability. Like most of the muni market, that index has performed poorly so far in 2022 as volatility has roiled returns. 

Intercontinental Exchange also in December acquired risQ and Level 11, two climate-change-focused technology firms, to manage climate change risk and grow ICE's alternative data capabilities in U.S. fixed income markets, munis included.

For Breckinridge, which has been incorporating ESG into its investment strategies for over 10 years, the emphasis is on ESG risks and how those factors influence and relate to more traditional credit factors, such as the amount of cash in the bank and the aggregate value of an individual’s tax base.

Institutional investors are armed with more data to analyze some of these risks and at a more precise level, Teras said. That’s leading to more questions directed to issuers than they have historically been used to receiving.

In one effort to gather more information on the ‘S’ in ‘ESG,’ Goldman Sachs Asset Management, BlackRock, Lord Abbett, Morgan Stanley Investment Management and Vanguard have partnered with minority-owned municipal underwriters Loop Capital and Siebert Williams Shank & Co. to disseminate a survey to issuers on racial equity and inclusion.

And while it is no secret that powerhouse investment managers have been at the forefront of the ESG muni efforts, they are not as keen to publicly dish out what exactly they are looking for. Several large asset management firms declined to comment for this article. Their hesitation mostly stems from the fact that they don’t want their competitors to know their strategies. 

Issuer response to growing demands
Investors want “affirmation that their money is being used to increase the health and wellness of citizens, to increase the sustainability of nature,” said R. Paul Herman, CEO and founder of HIP Investor. “They want positive progress toward a cleaner environment, like cleaner power and energy utilities, making sure that water utilities are delivering high-quality water.”

Certain issuers have embraced defining their ESG stories and the Government Finance Officers Association has released ESG best practices and its next debt-focused best practice is likely to focus on designated green bonds. 

But pushback against the use of ESG scores in public finance ratings is gaining steam in Republican-controlled states, with several officials calling ESG designations a political game.

But demand for the information, particularly among younger investors, will likely ensure that ESG is not going away as a factor in credit evaluations. 

Within the ESG space, Herman said, investors want three things: transparency, performance and accountability. One way to achieve these is recurring reporting, something he said is missing from the muni space. 

“Many of the muni issuers feel like that might be an increased cost burden, but the value to ESG-minded investors is high, and it shows that there's a seriousness to the commitment and a quantitative improvement,” Herman said.

The vast majority of the language in offering documents is standard disclaimer language from the bond counsels, Teras said.

“But the obligation is on both sides of the table,” Teras said. “A lot of the focus is on the perspective that issuers need to disclose more, but you also have to be realistic about what it is issuers can provide. It’s a two-way street.”

Specificity is key, he said. Issuers want to give the information but, Teras noted, if the request isn’t specific, it can get lost in the shuffle.

Pricing benefits, penalties and a broader investor base
Cohick said pricing differentiation will be driven by the industry and growing investor demand. As more millennials become investors with their own capital, he said, they will drive pricing premium for ESG and sustainability bonds.

Teras noted, “the jury is still out” on when there will be a pricing difference for issuing ESG debt.

At the moment, there aren’t widespread requirements from the institutional buyer base for ESG compliance. 

Existing internationally recognized standards and certification protocols, when properly adhered to by issuers, can offer investors a more vivid consideration of the current designation and green bond principles, said Jeffrey Lipton, managing director of credit research at Oppenheimer Inc. But, he noted, they’re voluntary best practices and guidelines, not requirements.

From time to time, Teras said, research will suggest a little bit of a premium for issuing a green bond, but that's still somewhat inconclusive, he said.

Lipton said any meaningful pricing distinction would have to be considered within a broader widening of credits.

The same is true for pricing penalties. Penalties for lack of ESG could be issued here or there, but nothing widespread, according to Teras. And it won’t happen until later.

“Investors are being armed with a lot more data than we've had in the past,” Teras said. “To the extent that trend continues, and as that data starts to trickle down to every investor in the market, you could start to see some sort of pricing penalty for issuers with perceived ESG risk.”

Lipton said demand from the institutional buyer base will be a driver for better disclosure and transparency.

“They will want to see specific disclosures, and if issuers don't comply, perhaps we need to get the regulators involved to pass certain requirements, and if you don't have proper compliance, that could potentially result in the assignment penalties,” he said.

Benchmarking would move the needle on ESG in the muni space, said Will MacPherson, co-founder and partner of VMG Ventures.

Aggregating enough data to allow for an investor to compare where something falls against a mean would be beneficial for the industry. MacPherson said it starts with the buy side.

“They’re doing the analysis on all of this, they’re fielding the information, pulling the risk assessments,” he said.

“Establishing a universal definition for impact or ESG is near impossible at this point, more recently due to politics,” MacPherson said. “If we can do benchmarking then maybe we can at least establish some standards to see where an investment falls on a curve relative to the rest of the industry.”