Identical or Fraternal? It’s Not Always Obvious.

By: Amy DiMarzio
June 10, 2021

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.

 

 

Sources: Bloomberg Barclays as of 6/7/21. Unemployment rates are not seasonally adjusted and as of April 2021. Selected credit metrics are as of 2020 annual reports. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. Copyright © 2021, S&P Global Market Intelligence. Reproduction of any information, data or material, including ratings (“Content”) in any form is prohibited except with the prior written permission of the relevant party. Such party, its affiliates and suppliers (“Content Providers”) do not guarantee the accuracy, adequacy, completeness, timeliness or availability of any Content and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such Content. In no event shall Content Providers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of the Content. A reference to a particular investment or security, a rating or any observation concerning an investment that is part of the Content is not a recommendation to buy, sell or hold such investment or security, does not address the suitability of an investment or security and should not be relied on as investment advice. Credit ratings are statements of opinions and are not statements of fact. The issuers/securities mentioned are for illustrative purposes only. This is not a recommendation to purchase or sell the issuers/securities listed.