US municipal bonds have traditionally been owned by US retail investors but their environmental, social and governance characteristics may attract overseas and institutional investors.

David Knutson, head of US fixed income product management at Schroders, told Markets Media that municipal bonds are generally not widely owned outside the United States. He explained that the US market is a natural habitat for municipal bonds, due to their related tax exemptions.

“However, there are inherent sustainable characteristics to a lot of municipal issuance, such as funding hospitals, water and infrastructure, so there could be growing demand among non-US investors,” he added.

For similar reasons, Knutson said Schroders is also seeing more interest from institutional investors, especially as issuance has evolved from financing general obligations to raising funds, for example, for healthcare or universities.

“I think this bodes well for the market and for more liquidity,” he added. “I think these could be interesting things we see in the coming years in the muni market.”

The United Nations-supported Principles for Responsible Investment highlighted in a report in January that the share of overseas investors in the muni market has been growing.

US municipal bonds fund key infrastructure & public services with clear environmental & social implications so are well-positioned for investors pursuing a thematic ESG approach.

Read our report on key issues for the thematic approach in this market: https://t.co/RxaWSAfsy7

— The PRI (@PRI_News) January 18, 2023

“Interestingly, the proportion of foreign investors in the muni market, albeit still small (at 2.9% of the total outstanding volume) has grown in recent years,” added the PRI. “One potential factor may be that insurers in the EU and the UK receive favourable capital treatment under Solvency II rules for investments in revenue muni bonds that fund infrastructure.”

The Commonwealth of Massachusetts issued the first green US muni bond in 2013 and the PRI said that a new labelled bond market has developed which enables issuers to earmark funding for projects that deliver specific sustainability outcomes.

“However, the extent to which such instruments are genuinely supporting sustainable finance rests on how robust and rigorous the standards used to issue the labelled bonds are, as well as on the underlying data and methodologies used to structure the bond,” added the report.

Data

Schroders has developed MUSE (Municipal US Sustainability Explorer), a proprietary investment tool that allows analysts to access dozens of data points across ESG factors and assign an overall sustainability score to every county in the US and many school districts. The tool also provides a forward-looking lens into the population that supports the municipalities that comprise each county.

Knutson noted that municipal bonds with the same credit rating tend to trade with very little differentiation in terms of price, but their long-term ESG characteristics may be very different.

“If you’re offered AA assets that are the same price and have similar historical fundamentals, the opportunity exists in taking a longer-term perspective with regards to their different ESG factors,” he added.

Lazaro Tiant, sustainability investment director at Schroders, said some of the physical sustainability risks that the asset manager reviews for municipalities includes potential damage to buildings from tropical storms, seismic activity or wildfires.

MUSE has been seen extended into modelling school districts and analysts may also consider factors such as the share of the population that has access to the internet and a computer at home, and capital expenditure compared to reading and math levels.

“It tells a story using hard data,” said Tiant. “We would also like to drill down into hospitals so the modelling is even more precise.”

Knutson said one of the areas where data is more nuanced is related to governance.

“You can certainly tell bad governance but sometimes good governance is not as immediately apparent, so we may have to look at indirect data such as corruption,” Knutson added. “We are constantly searching for other data to feed into our algorithm so it becomes even more predictive.”

There has been a backlash against ESG from certain states and counties. Knutson said Schroders role is to be the best possible stewards for clients’ capital and MUSE does not have a moral or ethical agenda.

“MUSE is simply a data tool that helps us source better long term- investments,” he added.

Outlook

In 2022 there were record outflows from the municipal market as interest rates rose, according to Knutson, but he expects the outflows will probably abate.

BlackRock said in a report that municipal bonds posted sharply negative total returns in February, erasing 83% of their historic gains since the start of this year. The S&P Municipal Bond Index returned -2.33%, bringing the year-to-date total return to 0.43% at the end of February.

“Rising interest rates weighed heavily on the market as strong economic data spurred expectations for a longer Federal Reserve tightening cycle and a higher terminal rate,” added the report.

Issuance was $20bn in February, 31% below the five-year average and bringing the year-to-date total to $43bn. Supply was outpaced by reinvestment income from maturities, calls, and coupons by nearly $16bn according to the report.

“At the same time, fund flows decelerated as performance turned negative, and robust inflows starting the month turned to moderate outflows by month end,” said BlackRock. “Although issuance is expected to remain manageable, continued interest rate volatility will pressure demand and could force further deleveraging.”

Additionally, BlackRock said historically rich valuations provide limited opportunity for material outperformance going forward until the future path of Fed policy is better understood.