Innovation in ESG municipal bond investing

Nuveen developed a proprietary ESG scoring methodology designed to evaluate a municipal issuer’s potential contribution to positive ESG outcomes relative to their peers. Using a comprehensive approach, Nuveen seeks to help clients achieve the investment benefits of municipal fixed income while aligning with their values and helping to provide positive outcomes for our communities.

ESG integration is underdeveloped in the municipal industry

Over the past decade, the integration of environmental, social and governance (ESG) factors into investment analysis and decision making has become common in public equities and corporate taxable fixed income. ESG integration into the municipal bond market, however, remains underdeveloped.¹

We believe this disparity exists for a few reasons. First, the municipal market lacks third-party ESG ratings from data providers, who offer valuable inputs into the equity and taxable fixed income markets. The sheer volume of municipal issuers — approximately 50,000 — and the shortage of ESG disclosure by these municipal issuers contribute further to the gap. As a result, very few municipal strategies explicitly integrate ESG factors or ratings, and those that do tend to focus on social and green bonds.

Another factor may be an underlying belief that municipal bond investments are inherently ESG oriented, since most municipal issuers finance public services like transportation, sanitation infrastructure, schools and utilities.

However, like any industry or asset class, municipal issuers may vary significantly as to how well they are governed and how constituents experience environmental and social outcomes. We believe that considering ESG factors in our municipal strategies may help encourage these positive outcomes.

Nuveen has a history of leadership

Nuveen’s long history and leadership in the municipal bond market, coupled with our responsible investing expertise, prompted us to develop a rigorous in-house, data-driven methodology to assess municipal ESG leadership, tailored to individual municipal bond sectors.

At the same time, we actively participate in organizations that have shaped the responsible investing field over the past five decades such as the Principles for Responsible Investment (PRI) and the Global Impact Investing Network (GIIN). We have advised on white papers with the UN Principles for Responsible Investment’s Sub-Sovereign Debt Advisory Committee, the Government Finance Officers Association (GFOA), the California Debt and Investment Advisory Commission (CDIAC) and the California Green Bond Market Development Committee (CGBMDC). We also participated in an ESG disclosure pilot program for municipal issuers with CDP (formerly Carbon Disclosure Project) and advocated for increased ESG-related disclosure in issuer documents to the Municipal Securities Rulemaking Board (MSRB).

By participating in industry groups focused on responsible investing as well as traditional public finance, Nuveen seeks to bridge the gaps in conversations that have historically left ESG out of the municipal market. Through these partnerships, Nuveen is helping to advance ESG disclosure and best practices in the field, bringing focus and client interest to this growing area.

Proprietary methodology identifies bonds that may deliver positive outcomes

Nuveen’s ESG municipal scores — developed in 2018 by senior members of Nuveen’s municipal research team and responsible investment team — seek to analyze a municipal issuer’s potential contribution to positive ESG outcomes relative to peers. Examples of positive ESG outcomes may include, but are not limited to, improvements in education, public health, housing affordability and public infrastructure. The team designed sector-specific models that consider relevant ESG factors and weighting criteria unique to each sector. The models are intended to score a meaningful portion of municipal issuers.

These scores are made available to research analysts and portfolio managers for consideration in the investment process. For client mandates with explicit ESG investment parameters, the scores are used in portfolio construction, as described more fully below.

Scoring identifies ESG leaders by sector

For each municipal issuer, sector-specific ESG factors are weighted and scored using a proprietary methodology to determine the overall ESG municipal score.

The weighted average of the ESG factor scores is aggregated to create an overall ESG score on a range of 1 to 5. A 1/5 represents issuers that are least/most likely to contribute to positive ESG outcomes relative to peers. Municipal issuers scoring 3 and higher are considered ESG leaders and typically represent 50% to 65% of our regularly traded municipal holdings.² Issuers scoring a 1 or 2 are considered ESG laggards. For example, Figure 1 shows how scoring would work in the hospital sector based on quality of care, patient satisfaction and affordability of care.

ESG laggards are generally not eligible to be included in municipal portfolios with explicit ESG investment parameters unless the bond has a qualifying use of proceeds with positive environmental or social impact (see the thematic use of proceeds section), or the bond otherwise meets the investment criteria of the client mandate.

Aligning municipal bonds to the UN Sustainable Development Goals

We believe the United Nations Sustainable Development Goals (SDGs), as shown in Figure 2, serve as a guide for how municipal bond investments may translate to real-world, positive outcomes. These 17 interconnected goals are designed to be a “blueprint to achieve a better and more sustainable future for all.”3 Underpinned by 167 development targets, the goals were agreed to by 193 governments in 2015 to go through 2030.

As part of our proprietary ESG scoring methodology, we developed an SDG alignment framework that aligns sector model factors to the underlying targets of specific SDGs. SDG-alignment indicates if an investment is directionally consistent with or linked to the overarching theme of one or more of the SDGs. Issuers with an aggregate ESG score of 3 or higher are generally aligned to the sector-relevant SDG.

Thematic use of proceeds bonds add to diversification

For strategies with explicit ESG investment parameters, we also have the capability to invest in municipal bonds with a use of proceeds intended to directly finance projects with environmental or social benefits. These bonds typically make up less than 15% to 20% of these portfolios, but may allow for diversification. They could have green, social or sustainable labels assigned by the issuer or could be unlabeled.

Unlabeled thematic bonds are identified through our active fundamental research process by reviewing the offering documentation to determine whether the projects are making a positive impact. For example, as shown in Figure 3, proceeds may be used for the construction or maintenance of water sanitation facilities. Social and sustainability bonds might support affordable housing development, the creation of education facilities or health care in low-income communities.

We also evaluate thematic use of proceeds by leveraging market standards such as the International Capital Markets Association’s SDG framework.

Applying ESG scores: Real-world examples

The consideration of ESG factors can be an important input when constructing portfolios. Municipal issuers with similar credit ratings may exhibit divergent ESG profiles.

Figure 4 compares the credit quality and ESG considerations of two city general obligation bonds. While they maintain relatively similar credit metrics and ratings, their ESG profiles (as measured by Nuveen’s proprietary ESG scoring methodology) are very different. Atlanta excels relative to its peers in accessibility to mass transit, clean air quality and spending on services including housing, education, public safety, social services and sanitation, which align to the underlying goals of sustainable cities (SDG 11). Conversely, Las Vegas lags relative to peers in safety, clean air quality and housing affordability.

Leveraging this analysis, an ESG leader may provide a more positive intended outcome (e.g., a higher quality of life) relative to its peers.

ESG factors serve as an additional evaluation tool

Municipal bonds are known for generating tax-exempt income and enhancing portfolio diversification, but they can also provide a way for investors to make positive contributions to society through their investments. Adding an ESG focus means analyzing sound environmental, social and governance practices by municipal issuers, which may result in positive outcomes for their constituents.

Nuveen brings together market-leading responsible investing and municipal investment capabilities by evaluating ESG scores at the municipal issuer level. Employing ESG analysis provides an additional lens with which to view the portfolio, helping clients seeking to align their investments with their values.