Investors are increasingly attracted to portfolios that can generate positive impact alongside market rates of return, but the range of eligible investments can frequently look too narrow, or confined to less-liquid areas of the market. What if so-called impact investment opportunities were hiding in plain sight, among more ‘vanilla’ parts of a traditional investment portfolio? Enter: municipal bonds. We discuss this opportunity with the GSAM Municipal team’s senior portfolio manager Benjamin Barber and Michael Kashani, global head of ESG portfolio management within fixed income.
Michael Kashani: The growing interest in this approach to investing is part of a cultural evolution. In general, clients are becoming more attentive to what their investments are actually funding, and more aware of the potential effectiveness of using investments to achieve their impact goals as compared to traditional forms of philanthropy.
Benjamin Barber: Managers are recognizing not only the strong investor demand for ESG-driven portfolios, but also that an ESG focus can lead to stronger investment fundamentals. Through our partnership with Imprint Capital—a leading ESG and impact investing firm that GSAM acquired in 2015—we have enhanced the consideration of ESG factors in our overall assessment of a sound long-term investment.
Barber: We don’t think investors need to give up return to have a positive environmental or social impact, so we look for yield opportunities to ensure these investments are ‘market rate’ rather than ‘concessionary’. However, investors should also be comfortable with the risk they’re taking, which can be challenging as impact investing tends to be associated with less-liquid private equity or venture capital markets. A big challenge for clients is therefore finding actionable entry points for market-rate impact investments in more-traditional portfolios.
Kashani: We believe that using ESG principles to construct high-quality municipal bond portfolios can provide clients a path to meeting impact goals. Municipal issuers are typically mission-driven; that is, their projects tend to address environmental, social and community development concerns. These issuers—namely, states and localities, municipal-related bodies such as transport authorities or essential service providers, and not-for-profit organizations—tend to have limited funding options outside the municipal market for their large-scale projects.
“Using ESG principles to construct high-quality municipal bond portfolios can provide clients a path to meeting impact goals”
Barber: We think municipal bonds are uniquely suited as a market-rate solution to the previously-mentioned risk/return challenges. Municipals are popular as diversifiers in mainstream portfolios in part because of their beneficial tax treatment—interest on municipal bonds is federally tax exempt, and in some cases also state and locally exempt. Municipal bonds are also typically considered a ‘sleep-well’ investment, given their overall high quality and low default rates relative to similarly rated corporate bonds1.
Kashani: Historically, non-US investors, along with pensions, foundations and endowments, have tended to be less involved in the muni market, as they can’t benefit from the key advantage of tax-exemption. Taxable municipal issuance existed in only a limited capacity until the Build American Bond (BAB) program launched in 2009 as part of the American Recovery and Reinvestment Act, which alone brought $170 billion of taxable debt into the market. The BAB program arguably also helped generate more taxable issuance, by introducing municipal bonds to non-traditional buyers, and allowing municipal issuers to get more comfortable raising debt in the taxable market. The total taxable muni market recently surpassed $300bn, offering an expanded opportunity set for investors who do not directly benefit from US-tax exemption to diversify their impact portfolios.
Barber: For a traditional investor, the thought of carving out a new section of their portfolio for ESG considerations or venturing into private markets to locate impact opportunities could be daunting. Our team starts with a conventional analysis of the credit-worthiness and competitive pricing of debt. Rather than limiting our focus to ‘green bonds,’ we look at a broad spectrum of issues and consider the integrity of their potential environmental and/or social impact. In keeping with our emphasis on maximizing the opportunity set, our research team has expertise across the credit spectrum.
Kashani: We can then begin targeting a higher allocation of a client’s municipal portfolio to sectors we expect to have a greater positive impact, such as school districts, community colleges, hospitals, and arts and cultural institutions. Water and sewer sector issuance is also often overlooked unless it carries a green label, but it’s important to remember that bond-funded projects to meet upgraded environmental standards were commonplace long before the green label became popular. Drilling down further, we might target, for instance, an issuance by a hospital to fund a new cancer center in a rural area with limited access to alternative treatment options, or the construction of a new elementary school in a challenged socio-economic area. On the other hand, we may also consider exclusions based on the revenue source, such as bonds funded by lottery revenue or a municipal utility issuance in a state that does not currently have a renewable energy requirement.
Barber: Flexibility is key. We cater to a range of approaches to investing for impact, from existing clients looking to adopt ESG principles as a guideline in their portfolios, to new clients targeting impact in a specific area. For instance, for clients new to this field we emphasize a thoughtful transition. We might advocate a gradual migration in accordance with the client’s needs and objectives, using an ESG focus to shift their existing portfolio allocations.
Kashani: Our focus on a thoughtful transition can help us avoid some pitfalls associated with impact investing. We often hear concerns from clients related to instances where their former managers may have been ‘reaching for impact’. In extreme cases, the manager may have targeted a transaction for its stated environmental or social benefit—for instance, an issuance funding the construction of a single-site charter school—despite that transaction being outside the client’s risk profile. More-common instances of ‘reaching for impact’ involve leaving the client underexposed to bonds issued in their state of residence, or hastily liquidating a holding that could be flagged for exclusion at a more-appropriate time. Either of these decisions could adversely impact portfolio performance.
Simply put—it’s not impactful if it’s not sustainable. We focus on issuances that fall within a client’s guidelines, with the aim of constructing well-diversified, high-quality, market-rate portfolios.
“Simply put—it’s not impactful if it’s not sustainable”
Barber: 2017 municipal new issue supply surprised most market participants by finishing close to the record supply levels experienced in 2016. This was primarily driven by record issuance in December 2017 as municipal issuers rushed to market due to the uncertainty surrounding tax reform.
The elimination of tax-exempt, advanced refundings (as mandated by the final tax reform bill), combined with many issuers pulling forward 2018 issuance to late 2017, has created lower primary market volume in 2018. Most market participants predict $300 to $325 billion in municipal new issue supply for 2018. This compares to an average of over $450 billion in annual primary market supply over the prior two years. The market will also closely watch for developments of an “infrastructure plan” in D.C. which could potentially drive new issue supply above current market expectations.
While initial expectations were for an increase in taxable municipal new issue supply as a result of tax reform – with municipal issuers refinancing previously issued debt in the taxable markets -- we have yet to see this materialize.