Looks can be deceiving, which is why we at IR+M espouse the benefits of incorporating environmental, social, and governance factors into our credit analysis. At first glance, two municipal bond issuers – a county and a city, in this case – may look remarkably similar. Even identical, like the famed actor-turned-fashion designer twins, Mary-Kate and Ashley Olsen. Please Google them – you’ll see what I mean. Definitely identical twins, right? Wrong! While they appear to be genetic copies of each other, Mary-Kate and Ashley are, in fact, fraternal twins. As they’ve aged, their nearly imperceivable variations have become slightly more pronounced. To return to our county and city example, these issuers have comparable credit attributes today, but may not tomorrow due to other considerations – namely E, S, and G. As investors, we believe it’s our mission to delve into the latent material factors that may cause issuers’ credit trajectories to eventually diverge.
To protect the identities of the county and city we’re referencing, we’ll refer to them as Coastal and Inland. Coastal and Inland are analogous in a myriad of ways. They both have outstanding general obligation debt that is secured by a full faith and credit pledge and are payable from taxes levied on taxable property. Both have large, diverse, and growing tax bases, and both have experienced considerable population growth over the last 10 years. Neither location is in a state that collects personal income taxes. Also, both issuers have healthy reserve levels, which should mitigate revenue declines during an economic downturn. Below is a sampling of metrics that we believe support their overall investment-grade ratings:
The comparability in fundamentals is pretty obvious, and justifies Coastal and Inland’s AA and AAA ratings, respectively. Based on historical yields, the market seems to agree:
Since the Coastal bonds were issued in January 2021, they have yielded, on average, 12bps more than their Inland counterparts. Basically apples to apples, right? Not exactly.
We believe that the market, and likely other investors, are overlooking a vital distinction between these two issuers – a distinction that may not be relevant today, but may be in the future. Location, location, location. When we evaluate a security, we consider it within a framework that is defined by 35 ESG-related material key issues. With the Coastal bonds, we are acutely focused on the potential impact of climate change. With the Inland bonds, we are not. Coastal’s near-term fundamental outlook is stable; its longer-term prospect is less sanguine. This issuer is situated in a state that is most vulnerable to climate change. It has experienced temperature and rainfall extremes that are probably tied to global warming. It has sustained salt-water intrusion, coastal erosion, and shallow flooding. In our view, a 12bps yield advantage over the Inland bonds, which has been even less lately, is not enough compensation to justify these longer-term risks. As a result, Coastal is out and Inland is in.
Incorporating ESG factors into our credit analysis enables us, as investors, to take a deeper look at an issuer that, on the surface, may look like something it’s not. It’s kind of like discovering that someone’s not an identical twin, but instead is a fraternal one.