By Ryan Gerlach, Paul Herman, Samuel Hecker and Eddie Bernhardt
Investors seeking impact apply their entire portfolio to build a better world while seeking a stronger and more resilient portfolio. With $24 trillion of corporate bonds and $3.7 trillion of municipal bonds, investors have many choices for integrating sustainability into their fixed-income.
Muni bonds are issued by governments (cities, counties, states, as well as regional water, wastewater and transportation systems) and non-profits (universities, hospitals and energy firms). More than half of muni bonds are held by individual investors [1] who seek lower risk and can benefit from no federal income tax on muni interest (several states offer tax-free muni bonds for in-state citizens). The tax-free status of muni bonds is associated with providing a public benefit to society.
But how effective and efficient are these government and non-profit issuers at delivering the outcomes that investors finance? Are less effective governments at higher risk of default? Does higher impact mean lower financial risk? Can low-income cities deliver as much benefit for citizens as high-income communities? How can investors benefit society by investing in the highest-impact bonds?
Investors can more easily “vote with their portfolio” by seeking out bonds issued by corporations, governments, sovereigns and agencies. By identifying known but ignored risks, impact ratings (developed by co-author HIP Investor) enhance fundamental credit analysis, which is performed by bond managers (such as co-author SNW Asset Management). The result is impact-rated bond portfolios for self-directed and advisor managed portfolios. An impact-rated bond portfolio can lower credit risk at similar yield – and spur more action by muni issuers towards delivering more benefit for society.
Issuers are graded on impact across five general categories inspired by Maslow’s hierarchy of needs – Health, Wealth, Earth, Equality, and Trust. Within these categories, the impact ratings encompass analysis of the intended societal outcomes and actual results, depending upon the type of the bond. Examples include personal safety and crime rates, the level of education in a community, ownership of assets and housing, and the representation of the community’s ethnic and gender profile as reflected in business ownership or government leadership, energy sources used for power generation. These quantitative results can be translated into a zero to 100 rating system, which we call a HIP Score. HIP represents the “human impact” and its connection to financial risk and return, or potential “profit”. These ratings avoid conflict of interest as they are paid for by the investor, not the issuer (as S&P, Moody’s and Fitch ratings are). Also, the ratings look at the current and possible environmental, social and governance risks over a 30-year period, not just the 5-year financials where the Big Three focus their assessments.
In concert with rigorous credit analysis, by firms like SNW, these impact-rated bonds could be more predictive of a community’s long-term health, stability and ability to repay debt outstanding. Every community possesses a range of knowable but typically ignored assets and liabilities. Kiki Tidwell, a trustee of the Tidwell Idaho Foundation, seeks to avoid the risks associated with fossil-fuel energy like coal. Bonds issued by electricity-generator InterMountain Power, which burns coal in Utah and ships power to California, do not price in the risks to the environment, such as the results of increased pollution – which could lead to financial risks from a future carbon tax.
Can these impact ratings correlate with defaults of muni bond issuers? There have been four relatively noteworthy municipal defaults in recent years – Jefferson County, AL; Harrisburg, PA; Stockton, CA; and San Bernardino, CA – and another issuer, Philadelphia, PA, which has not defaulted but has recently entered into serious discussions with creditors regarding its financial future. By using historical data, we can see how these issuers would have been rated for impact in advance of their default, thereby giving some indication as to whether the factors HIP measures could be predictive.
The defaulting or at-risk issuers were scored for the year 2000, eight to twelve years before any of them defaulted. After adjusting for inflation and other relevant benchmarks – for example, unemployment comparisons were made versus the year 2000 national average – the issuers were contrasted to the full universe of impact rated issuers. All defaulting municipalities, plus Philadelphia, score below average in their overall score compared to other impact-rated bonds. HIP Scores show that none of the defaulting issuers are rated above the 30th percentile in more than one sub-category of impact.
HIP’s Health category is highly correlated with the overall rating for bonds issued by cities, counties, and states. Tellingly, rated defaulting issuers score especially low on these factors with Wealth indicators also showing poorly.
• Compared to the national average, all five of the defaulting or at-risk municipalities had murder rates close to or greater than double the national average.
• Only Jefferson County’s high school and college attainment rates approached national norms, the rest fell well below.
• All five were in the top third in terms of obesity rates.
• Again with the exception of Jefferson County, all had poverty and unemployment rates roughly double the national figures.
The primary tool available to investors is credit ratings from the “Big Three” of Moody’s, S&P, and Fitch. Ratings agencies have been the subject of ample criticism in recent years, due demonstrated conflict of interest in their rating process as well as their role in the financial crisis [2]. But other questions arise around what these ratings actually tell investors. Credit ratings are failing to represent the meaningful future risk over the full life of an investment. Municipal financial information has long been noted to be “generally less reliable, less comparable and less timely than information about corporations.”[3] This fact, when combined with the size and high-profile nature of some recent defaults, has given cause to take another look at how debt is analyzed.
The success or failure of governments and non-profits can be measured in societal outcomes as well as the resilience of the bonds they issue. Many of the metrics that demonstrate the security of an investment are the same as those that indicate societal success.
A 2011 academic study analyzing municipal bond issuances throughout the country found that borrowing costs for more religiously and ethnically fractionalized communities are substantially higher.[4] The cost of capital paid by communities – essentially citizen-taxpayers paying more interest on the bonds issues by their government – with significantly higher rates of this social-fractionalization is associated with a difference equivalent to that between issuers with the highest credit ratings and those rated three to five notches lower, which connote higher risk and interest payments.
This means that, on the whole, taxpayers in more ethnically-fractionalized communities pay more to finance community projects. More fractionalized communities can be more divided in how to prioritize salient issues and allocate resources accordingly. This would seem to indicate a quantifiable financial cost resulting from societal unrest and the inability to address the needs of all citizens.
Meanwhile, the role health plays in economic productivity is becoming more widely understood all the time. One study estimated the US’s health care expenditure on obesity-related costs was $190 billion in 2005. [5] Over time, these costs are incurred by society as a whole and individuals alike.[6] Of the 10 states with the highest rates of obesity, nine of them impose a greater tax burden on the federal government than they contribute.[7 & 8] Furthermore, West Virginia and Mississippi, which rank one and two in obesity rates, respectively, both rank in the top three (excluding Puerto Rico) for federal spending over contribution. Conversely, seven of the ten states with the lowest rates of obesity contributed more in taxes than they received in government benefit.
It is no secret that successfully providing for the public good benefits from greater availability of resources. Consequently, it might be expected that wealthier communities can better provide for their citizens. HIP’s ratings do, in fact, bear this out: wealthier communities realize more benefit for their citizens. However, a low-income community does not imply a lower HIP Score. The large cluster of issuers whose median income fell near or below the national average – between $40,000 and $56,000 – can deliver just as much societal benefit as higher-income issuers.[9] Income establishes a floor for a community’s attributes but has little bearing on the ceiling.
This finding makes an argument for the importance of measuring outcomes, especially for cities with limited resources. We advocate for citizens and investors to demand an account of the outcomes that are generated with public expenditures; taxpayers should know what they get for their tax dollars. By the same token, bond investors ought to know whether their investments are building value and resiliency versus providing Band-Aids to poor management.
We envision that impacted-rated municipal bonds can help bridge this gap. Impact-rated bonds offer community-focused investors a tool that leverages currently available investment vehicles. Municipal bonds are, by definition, investments in the public good and ideally achieve some measure of positive social outcome. We see thoughtful, forward-looking investors using ratings to further direct their money towards investments that can maximize societal return in addition to seeking a more secure financial return. We envision their investors constructing portfolios that are focused on “local investing” in specific regions of the country as well as issues of concern, such as education or water resources. Conversely, investors may choose an “impact allocation,” to weight their bond portfolios across issue areas – like Health, Wealth, Earth, Equality and Trust, similar to Maslow’s hierarchy of needs.
Impact ratings of government and nonprofits can drive a push for positive outcomes. Analogous to the U.S. Department of Education’s competition for federal funding to improve student performance, the “Race to the Top“, we see potential for ratings to spur healthy, investor-driven competition among municipalities towards improved physical and mental health and safety, more eco-efficient transportation, enhanced income and financial wealth, a more equal society, and overall transparency of results.[10]
Investors of all types can channel their resources across their entire portfolio towards communities generating the best outcomes. In turn, communities would be incentivized to create meaningful results. Whether a national competition or one centered within a region, we envision data-driven metrics inspiring communities to compete not just on reading levels or test scores, but on a range of community indicators, striving to create the healthiest, most vibrant, and most livable places to live.
Impact-rated bonds issued by governments and non-profits offer individuals another channel for civic engagement and an opportunity by which to affect societal outcomes; investors may “vote with their dollars” by supporting the communities that build the outcomes they value. Following the axiom, “what gets measured gets managed,” impact-ratings can help guide our collective strength as investors towards building long-term value in our communities – and the foundation of resilience in our financial portfolios.
Article by Ryan Gerlach, a recent graduate the Presidio Graduate School, MBA (2013) who co-authored this research with Paul Herman is CEO of HIP Investor Inc., an investment adviser registered in California, Washington and Illinois, along with analyst Samuel Hecker and CEO Eddie Bernhardt of SNW Asset Management ( www.snwam.com ), an SEC-registered investment adviser. This is not an offer of securities.
Article Notes:
[1] Appleson, J., Patterson, E., & Haughwout, A. (2012, August 15) The untold story of municipal bond defaults. Federal Reserve Bank of New York.
[2] Dayen, D. (2012, December 19) SEC report on credit ratings highlight conflict of interest inherent in issuer-pays model. FDL.
[3] Ingram, R., Brooks, L., & Copeland, R. (1983, June) The information content of municipal bond rating changes: a note. The Journal of Finance. Volume 38, Issue 3.
[4] Bergstresser, D., Cohen, R., & Shenai, S. (2011, May 17) Fractionalization and the municipal bond market. Harvard Business School Finance Working Paper No. 1844685.
[5] Harvard School of Public Health (2013) Economic costs. Obesity Prevention Source. Retrieved from: http://hvrd.me/14Rg5uH
[6] National Conference of State Legislatures (2012, August) State-Level Estimated Annual Obesity Attributable Expenditures, by State (2009). NCSL.org.
[7] Bass, K. (2013, March 6) Coloradans least obese, West Virginians most for third year. Gallup. Retrieved from: Gallup Poll
[8] The Economist Online. (2011, August 1) America’s fiscal union: the red and the black. The Economist. Retrieved from: http://econ.st/qlmhHP
[9] United States Census Bureau (2012, September 12) Income, poverty and health insurance coverage in the United States: 2011. Retrieved from: http://1.usa.gov/RLLeVz
[10] The White House (2013) Education: knowledge and skills for the jobs of the future: race to the top. Whitehouse.gov.
