Muni investors see through mispriced risks to find alpha and impact

ImpactAlpha Editor

Dennis Price

ImpactAlpha, Dec. 11 – Lower risk: Bonds issued by high-performing school districts that serve low-income populations.  

Higher risk: Issuances that fund entertainment complexes that disrupt and displace majority-minority neighborhoods.

Rampant misperceptions, and mispricing, of demographic risk in the $4 trillion municipal bond markets has left opportunities for impact, and alpha, hiding in plain sight. 

Investors with more intentional strategies for racial equity are finding them, with help from advisors with unique analytics and ratings that can cut through legacy gaps in information and transparency.

To meet such investor demand, cities and other muni bond issuers are ramping up efforts to plan, execute and communicate the impact of equitable and resilient community development. Some are even realizing benefits in the form of lowered costs of capital for local improvement projects.

“Investors that are smart, that really want to beat the market, that want to see opportunities and not be beholden to past thoughts on race, are beginning to see the opportunity,” says Homero Radway of Activest, an investment research firm that will launch its “fiscal justice” fund strategy with early commitments next month (see, “Activest’s FIRE strategy seeks to bend the arc of municipal finance toward fiscal justice”)

Hear Radway discuss strategies for finding hidden risk and impact in municipal bonds, along with Kestrel’s Monica Reid, HIP Investor’s R. Paul Herman, Court Street Group’s Matt Posner and other Agents of Impact, on the next Call in ImpactAlpha’s Muni Impact series, supported by the Robert Wood Johnson Foundation, Wednesday, Dec. 13 (rsvp here). 

Disrupting the Black Tax

Activest’s FIRE Fund, for “fixed income racial equity,” will invest in bonds and other fixed-income investments in Black communities. Community Capital Management, a $4.5 billion asset manager based in Ft. Lauderdale, Fl., is helping Activest stand up the fund. 

Documentation of the “Black Tax” shows that, compared to other cities with similar risk-profiles, municipalities with higher proportions of Black residents pay higher borrowing costs to issue bonds. 

The misperception of demographic risk obscures actual risks that can undermine bondholders’ ability to get repaid. The real risk is the fiscal vulnerability cities find themselves in after decades of extractive and even racist policy choices, Radway says.

Louisville, Kentucky, for example, a majority white city with a strong credit rating, is now on the hook for annual payments for a bond issued to finance the construction of a stadium, after promised tax revenues failed to materialize. One factor in that loss of revenues, says Radway, is the stadium’s disruption and displacement of some of the city’s Black neighborhoods.

“Racism adds up,” Radway says. “If you are a bondholder, if you’re an investor, you are actually being cheated by this place that is not building an ecosystem that pays you well.”

In contrast, a 2019 municipal bond issued by Essex County, New Jersey helped finance the complete replacement of lead pipes in Newark, a majority Black city with a poor credit rating. The city completed the project, which is being hailed as a national model for lead replacement, seven years ahead of schedule.

Activest’s insights into actual risk provide an opportunity for investors to gain both a financial and an impact edge and push down the cost of capital for communities over time, he says. “That’s where we want to drive investors,”

Adasina Social Capital, a financial advisor and market activist, several years ago worked with Activest on a $60 million experiment in buying bonds in majority Black communities. Adasina believes increasing demand for bonds that fund well-managed and equitable projects can help to mitigate the Black Tax.

“If these communities are having difficulty accessing the market and face a higher cost of capital, there’s money to be made there,” Adasina’s Maya Philipson told ImpactAlpha. Driving up demand for bonds in predominantly African American communities, can drive down their cost of capital, she says. “So let’s be thoughtful but public about that because that will take away the arbitrage.”

A study from researchers from University of Pennsylvania supports the thesis that “better ESG outcomes and the equity thereof across racial identity groups, are associated with reductions in credit yields for municipal finance instruments.” 

With Clarion Call Capital, the new investment firm from Eric Glass, Adasina wants to be more intentional about investing in majority-minority communities. That includes refinancing mispriced bond debt at fairer rates.

“We are disintermediating the market,” Glass, a former muni bond portfolio manager at AllianceBernstein, told ImpactAlpha. “We don’t need banks. We don’t need bond counsel. We don’t need ratings.” With capital from value-aligned impact investors, “We’ll just provide you that loan directly.”

Information gaps

Some evidence for the fleeting arbitrage in higher-impact bonds can be seen in the demand for social, sustainable and other ESG-labeled municipal bonds. 

Issuers in New York, Chicago and Atlanta have all claimed that high-demand for their “social” bonds helped them “tighten the spread,” and drive a lower effective interest rate, reducing their cities cost of capital.

Such labeling remains scarce. Roughly 10% of the $158.4 billion of municipal bonds issued in the first half of 2023 were labeled green, social, sustainable or sustainable-linked. 

Many other bonds that are not labeled may nonetheless provide social and environmental benefits, and reduced risks. Investors able to spot impact in unlabeled bonds may benefit from a premium not yet recognized by markets, while driving down the community cost of capital over time.

Local governments must disclose information regarding use of bond proceeds, but typically with little attention given to social and environmental risk and impact. Ratings agencies that review bond issuances focus primarily on financial factors. Matt Posner of Court Street Group detailed the gaps in his recent Community Finance Brief. 

“If the marketplace were to begin to disclose more information related to impact metrics, and begin to take into account broader socio-economic and environmental elements that are relevant to these projects,” writes Posner, “more investors would invest in these bonds and the cost of capital for taxpayers would be reduced.” 

Spotting muni impact

The opaque market creates an opportunity for ESG and impact intelligence platforms to bring transparency and guide muni investors. 

Better understanding the impact of the underlying issuer is a way to identify potentially high impact bonds that aren’t labeled, according to ESG advisor HIP Investor. HIP has rated more than 122,000 issuers and other “impact entities” to illuminate their alignment with the Sustainable Development Goals, for example. Bonds issued by the impact entity can then receive a “rating enhancement” based on the actual social or environmental benefits from their use of the bond proceeds. 

Investors are using HIP’s ratings to build portfolios. ETF and mutual fund manager VanEck, for example, created the VanEck HIP Sustainable Muni ETF, which buys and holds muni bonds that align with targets for impact, the SDGs, climate and Opportunity Zones. 

As one example of hidden impact, HIP has identified 2,000 high performing school districts (of 18,000 nationwide in the U.S.) in low-income districts. HIP, for example, gives the Val Verde school district in California’s Inland Empire an above-average impact rating. Val Verde, where most kids qualify for a free or reduced-cost lunch, sends 60% of its students to college versus an average California public school graduation rate of 40%.

Labeled or not, bonds issued by one of those districts are “an opportunity for impact investors,” says HIP’s R. Paul Herman.

Hidden impact is abundant in muni markets, says Kestrel’s Monica Reid. The sustainability intelligence platform provides “second-party opinions” for labeled bonds, which serve as independent checks that the use of proceeds match industry guidelines. Reid says up to 60% bonds could qualify for some sort of social or sustainability label. Kestrel’s ESG/impact scores for non-labeled bonds focus on the strength of the financed infrastructure and other assets.

“There’s a lot of room there for growth and a lot of opportunities for investors to pick up impact,” says Reid. “If you’re looking for bonds that are green but not labeled green, because you believe that in the future green bonds are going to trade better, we tell you through our data.” 

Stocking the pipeline

Increased investor demand for impact and transparency is pulling through increased supply as well. In part to meet the needs of impact-oriented investors, municipal-bond issuers and other agencies are beefing up their capacity to drive more equitable and resilient development.

The cities of Atlanta, Dallas and St. Paul are among the initial issuer cohort of Public Finance Initiative’s ‘Municipal Bond Markets and Racial Equity Framework’ technical assistance and grant program. The program led by Lourdes German will help issuers better understand and communicate the racial equity and social impacts of bond issuances.

Agencies and institutions from Hawaii, Alabama, Tennessee and a half dozen other states have joined Lincoln Institute’s growing Accelerating Community Investment initiative. Earlier participants include InvestAtlanta in Georgia, Finance New Orleans in Louisiana and The Port in Cincinnati.

The community investment initiative helps entities design high-impact projects and think about raising capital not just in the municipal bond market but from mission-aligned investors and in the capital markets more broadly, says Lincoln Institute’s RJ McGrail.

McGrail, a former policy advisor to Massachusetts Gov. Deval Patrick, says cities that implement equitable plans and projects “are going to continue to be more competitive on the pricing for the capital that they need and more competitive on the sourcing of the entirety of the capital that you need.”