Why municipal bonds are emerging as a key ESG investment

When investors think about sustainable investing, they often focus on broad themes—such as water scarcity or clean energy—or individual companies that are leaders in environmental, social, and governance (ESG) practices.

But those looking to build their ESG portfolios could also tap into municipal bonds. Increasingly issued by state and local governments to fund public projects that can have a positive social or environmental impact—from schools in underserved areas to infrastructure for zero-emission transportation—muni bonds can clearly align with sustainability goals.

What makes them potentially alluring right now? New analysis from Morgan Stanley Research finds that muni bond valuations are still driven largely by the issuer’s credit rating, and not according to their ability to address ESG-related risks—a pricing advantage that may soon change.

“Right now, investors interested in building a more sustainable bond portfolio can do so without paying a premium,” says Samantha Favis, a strategist on the Municipal Fixed-Income team at Morgan Stanley Research.

“Looking ahead,” says Favis, “we think ESG factors could begin to impact bond performance as the connection between credit risk and environmental and social variables becomes harder to ignore.”

This pie chart shows how states allocate investors’ capital. By financing the construction, maintenance, and improvement of critical public infrastructure and community development, municipal investing largely overlaps with sustainability goals.

While markets haven’t yet emphasized ESG-related risks, these variables have a direct material impact on municipal credit ratings. For example, states and local economies must bear upfront costs to prepare for more frequent natural disasters caused by a warming climate.

What’s more, the impact of drought, flooding, extreme heat, and other climate events is far-reaching—affecting everything from agricultural yields and tourism to labor productivity.

Additionally, although social impacts are often harder to measure, states and municipalities tend to be more economically stable when their populations are healthier and better educated, as well as when they have higher levels of employment, homeownership, and gender equality. These factors, in turn, contribute to higher growth and better labor productivity, meaning that municipal bonds supporting these outcomes are contributing to positive ESG impact.

“At its core, ESG is about adding a new lens to risk management in the investment process by looking at ESG factors in addition to traditional financial metrics,” says Carolyn Campbell, head of Morgan Stanley’s ESG fixed-income research.

As the market recognizes the material impact of ESG factors on credit risk, this could begin to increase future muni valuations—meaning that investors are facing a narrowing window of opportunity to find the greatest value from muni investments in their ESG portfolios.

While the market plays catchup, Favis says, investors can consider how sustainability-related risks might affect a locale’s economic credit rating to find investment opportunities in public finance projects that aim to address potential ESG liabilities.

The source of this article, Why Municipal Bonds Are Emerging as a Key ESG Investment, was originally published on August 9, 2022.