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 Ben Barber and senior research analyst Michael Kashani.
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.
Ben 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.
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: 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.
Barber: It’s too early to be sure of the new Administration’s policy priorities and their impact. We see a risk that President Donald Trump’s environmental proposals could lead to deferral or even cancelation of some designated green capital projects in the near term, which could in turn constrain the supply of green bonds in the municipal market. That said, despite some uncertainty over energy policy, we think the trend toward increased adoption of renewable energy will continue, due to improving technology and declining costs.
Overall, we believe the municipal market will remain well placed to meet impact investing goals. Moreover, the opportunity set in the municipals market may benefit from President Trump’s emphasis on funding for infrastructure projects, as increased fiscal spending could include projects that would have been unviable in socio-economically underprivileged areas2.