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ESG

ESG-LabelledMuniFunds:FactorFiction?

By Jason Appleson, CFA, FRM & Lisa Cole — May 2, 2022

7 mins

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By their nature, entities that issue in the municipal bond market have substantial positive environmental and social impacts that make them ideal for investors seeking ESG investment opportunities. Municipal asset managers who are aware of this fit are increasingly touting their ESG capabilities; although these claims are often confusing as they conflate ESG credit risks with ESG impacts. This lack of focus, as well as the general lack of ESG disclosure in the municipal market, lead us to believe that this initial push is driven by marketing initiatives, rather than analytically honest ESG scoring. Within this environment, we question those offering municipal ESG funds who claim that they are materially different in terms of ESG impact from other, non-ESG-labelled municipal bond funds.

Measuring the Municipal ESG Market

As fixed income investors focus on climate risks and social inequality, ESG-related bond issuance has seen record growth in recent years. Comprised of government and not-for-profit issuers with a mission driven approach to operations, the municipal bond sector would seem a natural fit for ESG investing. Nevertheless, the number of municipal bond funds designated as impact funds is currently just a fraction of the overall ESG market. While there are now 16 municipal bond funds encompassing $2.2 billion in assets designated as impact funds, this is just a fraction of the 86 funds encompassing $90.4 billion in assets designated as impact funds in the non-municipal fund universe (Figure 1).

Figure 1

Muni ESG Funds Comprise a Fraction of Overall ESG Universe

Source:

Morningstar as of January 31, 2022.

However, this is beginning to change as shown by the volume of municipal bonds issued with an ESG designation, which has grown by more than 750% over the last 10 years (Figure 2).

Figure 2

ESG Muni Bond Issuance has Grown Over Time

Source:

Bloomberg, Barclays as of December 31, 2021.

Separating ESG Risk from ESG Impact

Although ESG risks are not new, they continue to attract heightened attention given the effects of climate change and social inequities. These credit concerns are captured by the internal credit rating we assign to every bond as part of the relative value assessment undertaken before every investment and include:

  • physical risks, such as climate change-related fires, floods, and droughts, which affect an issuer’s operations;
  • capital budget/leverage risks related to the need to finance adaptation projects, such as sea wall construction or airport relocations;
  • transition risks to economies currently dependent on fossil fuels or utilities powered by fossil fuels;
  • and demographic risks that affect future revenue generating potential and service needs

Measuring ESG Impact

By contrast, ESG impacts measure an issuer’s effect on the environment and society, regardless of whether it is credit material, and our research teams assign separate ESG Impact Ratings to each issuer they cover.1 These ratings assess an issuer’s policy- and mission-driven decisions and the degree to which those decisions minimize an issuer’s negative environmental and social impacts and contribute to positive impacts.

Our proprietary ESG impact ratings are a key tool in our ESG-oriented strategies, which seek to generate positive environmental and societal outcomes. For corporate credits, ESG impact ratings are determined based on an analysis of Key Performance Indicators tailored to each industry, using data provided by a number of third-party sources.

To provide sufficient granularity, we assign ESG impact scores on a scale of zero to 100, although these are broadly divided into five categories (Figure 3):

Figure 3

Five Categories of ESG Impact Scores

Source:

PGIM Fixed Income. The above information is shown for illustrative purposes only. ESG ratings are subject to change without notice. Please see the Notice for additional disclosures.

As our research teams do for each issuer they cover1, PGIM Fixed Income municipal analysts assign ESG Impact Ratings, which measure environmental and social impacts and the degree to which these are impeded or supported by governance considerations. Assessments are derived using information that is available through the Electronic Municipal Market Access (EMMA) system to ensure a consistent basis for measurement. Not surprisingly, given the strong alignment of municipal issuers’ missions with ESG goals, ESG Impact Ratings for municipal bonds are clustered in the upper end of this scale. 

Notably, the weighted average ESG Impact Rating on our representative national municipal bond portfolio is 67.7; investments in this fund are not subject to any minimum ESG Impact Rating threshold. This score is higher than the average ESG Impact Rating of 60.4 for our global corporate ESG bond portfolio, which does limit investments to meet client ESG objectives.2 This comparison illustrates the viability of municipal bonds as an attractive option for investors seeking an investment strategy that generates positive environmental and societal outcomes.

ESG Data and Municipal Credits

We seek to apply the same approach used for corporate credits when assigning ESG impact scores to municipal credits. However, we are limited by the ESG data that is available and frustrated by issuers’ and investors’ tendency to conflate ESG Risk with ESG Impact. Limited disclosure by municipal issuers restrains our ability to apply our methodology beyond a certain number of factors.

Additionally, when looking at a handful of municipal issuers that have issued both “green” certified and “non-green” certified bonds, there is effectively no premium for investing in municipal “green” bonds, which would be an indicator of higher demand. By comparison, investment grade ESG corporate bonds priced 2.4 bps tighter on average in the primary market compared to non-ESG bonds over the last four years, and we expect to see this differential to increase over time.3

To be sure, municipal market participants increasingly acknowledge the need for more robust ESG-related disclosure, and its availability is growing. However, it tends to be primarily related to ESG risk disclosure provided by rating agencies, issuers, and third-party vendors dedicated to ESG investing. As only a subset of ESG impacts tend to be immediately credit material, these data fail to give a full picture of an issuer’s ESG impact profile. The few that are focused on municipal ESG Impact concentrate on specific sectors rather than the broad municipal market. 

Without the benefit of more robust ESG disclosure, our muni credit analysts work with what is available to measure ESG impacts and assign ESG Impact Ratings to municipal issuers. For example, for water and wastewater utilities, we rely on measures of capital investment as an indicator of environmental impact, as most utilities’ capital improvement plans are primarily devoted to meeting environmental regulatory requirements.

For governmental credits (states/counties/cities/school districts), we recognize the most significant ESG impacts are policy driven. To assign state-level ESG impact scores, we rely on third-party sources that score and rank the states on environmental policies (e.g., GHG tailpipe emissions standards, transit funding, utility standards), performance against various social benchmarks (access to education, food insecurity, life expectancy, affordable housing availability), and governance measures focused on accountability and transparency. These scores are combined into a single raw score that we map to our 100-point ESG impact rating scale.

What’s Next for Muni ESG?

While ESG investing is not as developed in the municipal market as it is in the corporate market, interest in this area is growing. However, we continue to expect this segment of the market to be driven by marketing considerations over the short term and evolve in fits and starts. ESG investors demand consistent, data-focused impact disclosure, which is costly for issuers to provide in the absence of a bond pricing incentive. Nonetheless, at PGIM Fixed Income, we have developed an approach to measuring ESG Impact within the municipal bond market that aligns with more developed corporate ESG assessments, which may provide a roadmap toward better dissemination of ESG information, more standardized disclosure, and a more robust assessment of an issuer’s overall environmental and societal impact.

1The coverage universe for ESG Impact Ratings includes nearly all issuers where we hold a position, except for those where our position size across the firm is de minimis and certain tax-exempt munis, provided these are not held in accounts that utilise the ESG Impact Ratings. Certain new issuers may also not have an ESG Impact Rating assigned in our systems on a transitory basis due to timing constraints.

2As of March 31, 2022. PGIM Fixed Income’s ESG process may yield different results than other investment managers, and PGIM Fixed Income’s ESG rankings and factors may change over time. For illustrative purposes only.

3 Reuters, Global issuance of sustainable bonds hits record in 2021. December 23, 2021.

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  • By Jason Appleson, CFA, FRMHead of Municipal Bonds, PGIM Fixed Income
  • By Lisa ColeCredit Analyst, Municipal Bond Credit Research, PGIM Fixed Income
Important Information

The comments, opinions, and estimates contained herein are based on and/or derived from publicly available information from sources that PGIM Fixed Income believes to be reliable. We do not guarantee the accuracy of such sources or information.  This outlook, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. Past performance is not a guarantee or a reliable indicator of future results. ESG investing is qualitative and subjective by nature; there is no guarantee that the criteria used or judgment exercised by PGIM Fixed Income will reflect the beliefs or values of any investor.  Information regarding ESG practices is obtained through company engagement or third-party reporting, which may not be accurate or complete, and PGIM Fixed Income depends on this information to evaluate a company's commitment to, or implementation of, ESG practices.  ESG norms differ by region.  There is no assurance that PGIM Fixed Income's ESG investing techniques will be successful.

Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of May 2, 2022.

PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.

These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. Clients seeking information regarding their particular investment needs should contact their financial professional. These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. All investments involve risk, including the possible loss of capital. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or an y investment management services and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.

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PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iii) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”); (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) PGIM Netherlands B.V., located in Amsterdam (“PGIM Netherlands”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom, or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.

In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 - Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.

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