Digging Deeper into Municipal Credit for Impact and Total Return
By David Falk
In searching various dictionaries for the most frequently observed terms used to define “meaningful” one would readily find these terms:
Important, Purposeful, Useful, Significant
We think many would agree that these words accurately describe the main characteristics socially responsible investors care about in building an investment portfolio. It would not be at all surprising to see “Impactful” also used to define something that is meaningful. In recent years registered investment advisors, high net worth individuals and some institutional investors searching for meaningful or impactful fixed income investment opportunities have landed on municipal bonds. The purpose of many kinds of projects and programs financed with municipal bonds certainly satisfy the objectives of many SRI investors, but to date, most of the focus has been on high grade municipal securities — in both mutual fund and separately managed account formats. However, at Shelton Capital we believe that SRI investors looking for meaningful social impact and meaningful total return should consider high yield municipal bonds.
To get a sense of the opportunity in high yield municipals relative to high grade municipals it is helpful to review recent historical index returns. While many bonds in the various benchmark indices would not meet many investor’s impact criteria it is still useful to compare returns to understand the magnitude of the opportunity in high yield municipals. For example, over the past five years the ICE BAML US Municipal High Yield Securities Index has a cumulative return that
is 14.53% more than the return for the ICE BAML US Municipal Securities Index.
There are many high yield municipal bond investment opportunities to be found in infrastructure, housing, solid waste management, renewable energy, health care, education and other sectors. Unlike most high-grade financings, many of the higher yielding bonds are funding projects which utilize new technologies and/or employ complex financing plans with unique public-private-partnership models. Each of them is designed to address specific community or regional needs and problems. They require careful underwriting in connection with the initial investment decision as well as robust ongoing surveillance to monitor project performance.
Examples of High Yield Municipal Bonds with Meaningful Impact
Let’s consider a couple of examples in various sectors:
Solid Waste Management: A non-rated project in Northern California employing a patented production process to produce high quality environmentally friendly medium density fiberboard (“MDF”) using annually renewable rice straw as its feedstock. The straw is a by-product of rice production and must be disposed of following each harvest. Since 1991 when post-harvest burning regulations were initiated, no other economically viable post-harvest uses for the straw were developed. Now the rice straw will be converted into MDF which has broad commercial and residential demand in remodeling markets.
Infrastructure Finance: We have invested in a variety of “Managed Lane” projects in Texas, California and Virginia that employ congestion pricing technology and high occupancy vehicle lanes to regulate traffic flow based on changing demand patterns. These projects meet important regional economic development requirements by more efficiently moving the population between home, work and school and at the same time reduce carbon emissions through reduction of idling time. The credit structure of these projects is generally in the BBB- range.
Health Care Finance: There are a wide variety of non-profit sole provider community hospitals as well as larger systems that borrow in the municipal market and that deliver important health care services to their communities and regions —- in both urban and rural settings. These organizations manage their businesses in a highly regulated and competitive environment undergoing rapid change. One example is Ballad Health, a large multi-hospital system serving 29 counties of Northeast Tennessee, Southwest Virginia, Northwest North Carolina and Southeast Kentucky. The system is comprised of 21 hospitals, including three tertiary medical centers, a dedicated children’s hospital, community hospitals, three critical access hospitals, a behavioral health hospital, an addiction treatment facility, long-term care facilities, home care and hospice services, retail pharmacies, outpatient services and a comprehensive medical management corporation. Ballad is focused on delivering quality managed care and population health management to its service area. A high level of the service area population is elderly and the government payor (Medicare/Medicaid) percentage is over 65%. Ballad is highly focused on specific service area needs including mental health/addiction issues and children and family health. Recent focus areas have included diabetes and pediatric asthma. Ballad Health has split credit ratings of Baa1/A-/A by Moody’s S&P and Fitch, respectively.
Affordable Housing Finance: Multi-family rental housing is another area of focus in the high yield municipal bond market. We recently invested in several non-rated financings located in both Northern and Southern California designed to preserve and add to the availability of low and moderate income rental housing in the respective communities. Significant units were preserved via public acquisition of existing properties with significant cost savings (and related control of rental costs) achieved through private management.
Renewable Energy Finance: We also recently invested in municipal bonds issued by American Municipal Power, Inc (“AMP”). The bonds financed the cost of supplying electricity from 13 solar photovoltaic generating facilities in Delaware, Michigan, Ohio and Virginia. This financing helps
AMP continue to expand the amount of renewable assets in its overall generation portfolio. AMP is rated A2/A by Moody’s and S&P respectively.
Please note that while the traditional use of the term “high yield” or “non-investment grade” refers to anything below the triple-B category, when we talk about high yield municipal bonds, we include securities ranging from single-A to non-rated. This is the area of the municipal market where there is historically more credit spread, a wide variety of investment opportunities that may fit an SRI investor’s objectives and adequate trading liquidity to enter and exit positions as required.
Finding the Opportunity
It is precisely the use of new technologies, the application of complex financial structures dependent on successful performance by multiple parties and the regulatory challenges and uncertainty in areas like health care that present the risks that must be carefully analyzed. But it is these same factors that also present the opportunity for receipt of meaningful returns. Our job as an investment manager is to carefully underwrite each of the unique risks inherent in any investment opportunity, determine that the project will perform satisfactorily and ensure that we are being adequately compensated for the identified risks relative to other opportunities.
Given the opportunity for meaningful impact plus meaningful return we think high yield municipals deserve a closer look for SRI portfolios.
David Falk is a Portfolio Manager at Shelton Capital Management in Greenwich, Connecticut. Contact him at firstname.lastname@example.org
Past performance is no guarantee of future results. Investments involve risk. This information has been prepared from sources believed to be reliable. The views expressed are as of the date of this writing.