Environmental Social Governance

  • Jun 23 2022
  • by
  • Analyst AZA
Environmental Social Governance

Environmental Social Governance in Municipal bond market

This article will be clarifying equities and ESG in the municipal markets. We will be looking at the risks, disclosure, and adoption. This article will be covering some of the best practices and opportunities in the municipal markets, for better integration of ESG. There is about a nine and a half basis points pricing differential for corporate ESG bonds in the United States fixed-income markets. Even though it has forty-three billion worth of ESG bonds in its muni market, the pricing differential is just not evident. We have seen from time to time, in the day specific and deal-specific, that the proclivity for core orders on long-maturity bonds to be upsized with green and social bonds, in a pricing process to swing pricing leverage to the issuer to lower TIC. The good news is that market technical in municipal markets are still positive for issuers, meaning they have relatively low supply and strong demand.

During the marketing and underwriting processes, they are partially targeting ESG investors, and what they try to tease out is that what are the metrics that matter to those ESG investors that may be enticed to upsized orders. For example, when we look at green bonds, investors care about sustainable activities like resource conservation, pollution prevention, and restoration, but if you can include environmental Justice to address that, it might increase the demand. We have also seen an increased interest in the retail side of the market and that opens up questions like, what are the metrics. In primary markets, there's no quantifiable pricing differential but in the secondary markets, there is some difference in how ESG bonds are trading relative to the vanilla bonds.

There are trading platforms that are geared toward professional retail traders, but most of them don't have a centralized repository of information that their retail clients can utilize to access whether or not the actual issuance retains the impact that they were promising in their primary offering. If we think back to the 1990s, it's argued we saw some nascent activity we experienced social bonds arising even in the tax credit context, and when we think about the wide variety, scope, breadth of the market, and all of the sectors that can be financed under each label, what you measure will be different depending on what is financed. It also argued depending on how you look at integral pieces of the plan of finance plays on how we think about the outcomes.

For example, if you were thinking about housing bonds with the label social and that a housing project is happening in what is called the difficult development area, you might see measurements around the changes in the composition of area median income. There have been many studies done by the government accounting office looking at mandated areas in the tax credit context, they want to see what is the progress that is happening beyond the financial outcomes. There have been a lot of difficulties in measurement, that limit and inhabit what story we can tell with econometric analysis. Taking a step back from that, there's another piece of measurement that should be happening at the issuer level, that is important to the market context, which is when you put forward the effort as an issuer to measure and develop a rigorous framework to describe what is social in the story in your official statement, is that impacting pricing?

Particularly when you go to the primary market to sell bonds for the first time, to my knowledge that is one of the biggest unanswered questions in the market because it's hard to even wrap your arms around the changing nature of disclosure, where we put issuers at the top of the spectrum and consider them to be more mature practices than those who are less rigorous. I believe that we are going to see a real change in the type of information and the way that we can use it so that we can wrap our arms around that question more meaningful and thoughtful. Hopefully, we will start to build an alignment, when we are seeing investors come to the table and issuers are oversubscribed and we are seeing stronger pricing. Their question is, can we find factors that we can say in social and sustainable green bonds lead to that.

The challenges of measurements also become more pronounced because we know that not all bonds come as a single issuance. there are other stakeholders, whether it's investors, issuers, or rating agencies, thinking about what are the critical next steps for them to better think about the assessment of investor pricing around social risk. In 2021 there were 1.6 trillion dollars of new issuance of green social sustainable bonds which was twice as much as what we saw in 2020. Remember that 20 years ago there was no green sustainable range bonds market and today we have 1.6 trillion dollars of new issuance, so there is a huge amount of supply coming to the market and that's because we have seen an incredible amount of demand from investors around the world, who are seeking to invest along the lines of sustainability and are looking for ESG labeled bonds as a way to align their investment portfolios to the ambition around sustainability.

What we saw in 2020 and the back half of 2019 was that there was a pretty significant supply-demand imbalance in the global marketplace. There was not enough supply to meet the present demand, and we started seeing significant pricing pressures across the board. In 2021 we saw better pricing and we saw on-par pricing relative to traditional bonds of issuers. Over the past several years we have seen that there is a variety of benefits that issuers are bringing forth from issuing these bonds some of which are diversified investor bases. Typically, when you see a green label bond come to the market, you are seeing a different investor base going into that bond than what you would typically see in the general markets. That's true in the case of corporate and municipal issuers.

It's essential that we as traders, familiarize ourselves with the bonds market because a lot of investors have them in their portfolios and if there would be some significant liquidation, there's potential it could spill to other sectors of the financial system. Thanks for reading and good luck.

During the marketing and underwriting processes, they are partially targeting ESG investors


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