When we published our 2020 outlook early this year, we highlighted rising awareness of environmental, social, and governance (ESG) risks as a key theme for the upcoming year. In the outlook, we noted that while incorporation of ESG factors isn’t a recent development for our investment process, market awareness around this topic is increasing. Now that we’re halfway through the year, we believe that ESG-related rating actions, especially downgrades, as well as pricing effects, will continue to be important trends through the end of this year and beyond.
It’s important to note that ESG isn’t something that’s new to either ASI or the municipal bond market. Incorporating non-financial factors into credit analysis certainly isn’t a novel idea, even if doing so hasn’t always been labeled as “ESG.” In fact, the credit rating agency S&P estimates that 34% of its rating actions in 2017-2018 had something to do with ESG factors (mostly governance related) and we agree that non-financial factors are certainly important enough to materially alter a credit profile.1
In fact, the coronavirus pandemic prompted investors to demand – and receive – more information on non-financial risk factors.
Socioeconomic trends, government policy, natural disasters, and management practices, among other non-financial considerations, have always been critical for analyzing credit quality and identifying risks that may not be obvious from financial statements alone. And now, the coronavirus pandemic has materially changed the credit picture for almost every muni market sector. It’s more clear now than ever before just how much ESG factors can affect an issuer’s risk profile. In fact, the coronavirus pandemic prompted investors to demand – and receive – more information on non-financial risk factors. The Municipal Securities Rulemaking Board states that its disclosure document repository has received over 10,000 coronavirus-related disclosures from muni issuers through June 21, 2020.2
Notably, the municipal sector also generally lends itself well to the related, but different, trend of impact investing. Municipal bonds present the opportunity to make a positive impact by investing in local governments, schools, roads and more. Most investors would agree that providing capital for local projects like these is a way to contribute to the social good, without sacrificing returns. Although we consider a bond’s social impact, it’s important to mention that we see analysis of impact as entirely different from analysis of ESG factors and their effect on valuation.
Still, this doesn’t mean that all municipal bonds are created equal. Environmental, social and governance risks can come in all shapes and sizes, and they can have very different effects on bond pricing over different time horizons. That’s why when we look at ESG factors, we focus on how likely they are to effect pricing during the period over which we hold the bonds. We weigh the risks and opportunities that these factors generate to determine if the security offers returns in line with our analysis. One way that ESG factors can impact market pricing is through rating actions. We think that as certain ESG factors — namely cybersecurity, climate change risks and most recently coronavirus — become more pronounced, we’re likely to see more rating downgrades related to these factors.
Climate change has present-day, not just future, implications. We only see climate-related risks growing in the coming years. Our assessment of environmental risks and opportunities takes into account an area’s susceptibility to physical risks, such as flooding or fires, the time period over which we think these risks will affect the credit, and, importantly, what measures management is taking to avoid or prepare for these risks. For example, meteorologists are predicting that the 2020 Atlantic hurricane season will be especially active, and local governments will be especially challenged in their responses as budgets are already stressed by the pandemic.
We expect to see robust planning by municipalities that are susceptible to this risk, and we expect to be compensated for the risk through additional yield. Rating agencies are starting to incorporate environmental factors more explicitly into their rating process. At the same time, the media is beginning to recognize the risks that climate change and other environmental factors can pose for municipal bonds, and how those risks may not yet be reflected in prices. Although there are exceptions, on the whole, we see environmental risks as much more relevant for municipal bonds than environmental opportunities, so we see this as a negative for the market in 2020 and beyond.
The social category encompasses a broad range of factors, and includes some very important considerations for municipal bonds. In our view, the S in ESG involves both the overarching policy environment in which an issuer operates and the demographic trends of the market. For example, charter school policy is a highly politicized topic and each state’s specific policies relating to charter schools heavily influence the operating profile for schools in that state. Any change in policy as it relates to charter law is something we’ll monitor closely, as it could have either positive or negative impacts for the charter schools in that state.
Similarly, an issuer’s relationship with its employees can have a major impact on credit. For example, the city of Chicago’s dispute with its teachers’ union led to a strike that shut down schools for 11 days. Additionally, cyber threats put issuers both large and small at risk for potential financial and reputational damage. So this is another area where we predict increasing scrutiny over the next year. Management teams should show that they recognize these virtual dangers and have processes in place to address them. The first S&P downgrade based partially on a cyberattack, of a small hospital in West Virginia in 2019, could be the first of many more to come as cyberattacks become more frequent.
Governance issues are probably already familiar to investors, and indeed, a management assessment has always been a critical part of our credit-review process. In all sectors, a qualified and honest management team can be the difference between success and failure, and municipals are no different. In addition, a strong management team makes an issuer more likely to address and remedy problems, including the environmental and social risks mentioned above. In sectors that are highly exposed to risks and uncertainties related to the coronavirus pandemic, like higher education or transportation, we expect to see management teams examining and planning for various possible future scenarios.
Not just another hot topic
ESG analysis may not be new, but as more and more market participants become aware of certain risks, they are more likely to recognize the material effect on municipal valuations. ESG is more than just a “hot topic.” Understanding relevant ESG factors is critical for fully understanding an issuer’s credit profile. The challenge for investors remains vetting which risks and opportunities are the most relevant, and how these should change the yield that investors demand in return.
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.