The letters ESG surrounded by trees and windmills. In the forefront, well dress businesspeople look forward through binoculars.

Can Responsible Municipal Bond Portfolios Deliver Both Positive Social Impact and Strong Financial Returns?

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Lauren Kashmanian

Director, Portfolio Management and Responsible Investing

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Does implementing an ESG municipal bond strategy affect investment performance? We explore common misconceptions and why we think responsible investing can help long-term returns.


Responsible investing grabbed headlines in 2022. Surveys suggest a growing percentage of investors are looking to incorporate environmental, social, and governance (ESG) factors into their portfolios. Investment strategists are predicting more growth for the fixed income ESG markets in 2023, higher ESG-labeled bond issuance across various segments, and increasing flows into responsible bond funds and strategies. 


The ESG market faces no shortage of skepticism alongside its growth. A persistent concern is the widely held misconception that ESG fixed income investments will underperform traditional strategies. Many investors don’t want to sacrifice returns to implement this strategy. We contend that they don’t need to give up performance to meet their responsible investing objectives.



Does implementing a municipal bond ESG strategy affect investment performance? 


Beliefs that responsible investment strategies may underperform traditional investment strategies derive from various factors. One consideration is that the universe of potential investments for those investment vehicles that incorporate ESG principles is smaller than the total investable universe, restricting investors to a lower percentage of total supply. For example, ESG-labeled municipal bond issuance in 2022 was $43.8 billion, or approximately 11.4% of total municipal bond supply, according to Bloomberg. This is up from 9.7% of total municipal bond issuance in 2021.


However, municipal bonds beyond those labeled as green, social, and sustainable can have positive social and environmental benefits even if they aren’t explicitly categorized as such. Bond issues for funding public schools, water and sewer infrastructure improvements, and renewable energy projects may not carry green or social bond labels, but they still have a clear environmental or social purpose. It’s important for investment managers who implement a responsible investing strategy to use a comprehensive and holistic ESG research framework for evaluating bond issues. This expands the pool of potential investments beyond the smaller percentage of bonds explicitly labeled as green, social, or sustainable. A larger universe of prospective unlabeled ESG investments presents an opportunity. It allows investors to uncover relative value in the market and achieve both strong social and financial returns in their investment portfolios.



Is there a “greenium” for ESG-labeled bonds?


A related concern is that bonds labeled as green, social, or sustainable will yield less than unlabeled bonds. This might lead to overall lower portfolio yields—a so-called greenium. This is the amount by which the yield on the green bond is lower compared with a conventional bond from the same issuer. One explanation for the greenium is that investors are willing to pay more for the perceived social benefits of investing in a green-labeled bond. Currently there’s no premium in the municipal bond market for green versus non-green bonds from the same issuer. The State of Nevada recently brought a deal to the market that included a green bond tranche earmarked for safe drinking water projects and a non-green-labeled tranche for general purposes. Bonds in the same maturities in both the green and non-green tranches were priced at the same yields. The State of Connecticut also recently issued tax-exempt bonds, with one series labeled as social bonds for public school projects and the other series unlabeled and earmarked for general purposes. The social bonds were priced at equivalent yields to the conventional non-labeled bonds. Investors don’t need to compromise to implement an ESG strategy in today’s market environment, because the yield of ESG portfolios will be like that of traditional portfolios. 


More strategists are recommending greater allocations to ESG-labeled bonds due to increasing flows. This indicates growing investor demand that could lead to outperformance for green-, social-, and sustainability-labeled bonds and in responsible investing strategies that use these as a core investment. Advisors and their clients may therefore get an opportunity for increased future returns with no premium priced in.


Empower portfolios through responsible investing

Green bond pricing examples


Green bond pricing examples

Sources: Bloomberg and S&P 500®, 2/17/2023. For illustrative purposes only. Not a recommendation to buy or sell any security. It should not be assumed that any of the securities listed were or will be profitable. 



Does fixed income ESG investing bear extra credit risk?


Some investors hold the misconception that responsible investing strategies have added credit risk. This could stem from preconceived notions around project-based financing that’s sometimes issued through the fixed income markets. These projects can carry more credit risk and lower credit ratings. However, many issuers of sustainable municipal bonds—including those who issue unlabeled environmental and social projects—are often rated investment-grade A and higher. These issuers have the same credit rating for both general purpose bonds and those with a specific environmental or social use of proceeds.


We believe investment managers should undertake fundamental credit analysis to ensure the creditworthiness of issuers held in responsible investing portfolios, as with any investment-grade portfolio. The issuer’s credit rating must meet the minimum credit rating of the underlying investment strategy before managers consider a bond issue for an ESG-focused portfolio. The process of ESG integration, in addition to fundamental credit analysis, can help with additional long-term risk mitigation and provide additional credit insight.



The bottom line


There’s no penalty to performance for incorporating the principles of ESG into a long-term investment strategy. We believe investors can in fact improve long-term returns by incorporating ESG factors into the investment process. ESG integration is becoming an increasingly important consideration for investors who are concerned about long-term risk mitigation. By considering ESG risks in fundamental credit analysis, investors can avoid issues that could potentially underperform the market over time. In addition, as demand increases for sustainable bonds, the fixed income markets appear to be anticipating relative outperformance for ESG-labeled bonds in the future. And with the right partners, advisors and clients can avoid potential issues in their responsible investing journey by considering the risks and preparing for them.




An environmental, social, and governance (“ESG”) or “responsible” investment strategy limits the types and number of investment opportunities available to the investor, and as a result, the investor’s portfolio may underperform other investment strategies that do not have an ESG focus. The ESG investment strategy may result in investments in securities or industry sectors that underperform the market as a whole or underperform other strategies that apply ESG standards. An issuer’s ESG performance or the investment advisor’s assessment of such performance may change over time, which could cause the investor to temporarily hold securities that do not comply with the investor’s responsible investment criteria. In evaluating an investment, the investment advisor is dependent upon information and data that may be incomplete, inaccurate, or unavailable, which could adversely affect the analysis of the ESG factors relevant to a particular investment. Successful application of the investor’s responsible investment strategy will depend on the investment advisor’s skill in properly identifying and analyzing material ESG issues.

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