The 2016 US presidential election sent many champions of social justice and environmental stewardship reeling. The anticipated appointment of officials that question—or outright reject—climate change is rightly concerning, as are the threats to equality and inclusivity implied by a truly toxic presidential campaign.
Among the many concerned constituencies are impact investors—those who actively allocate capital to investments that demonstrate positive environmental and social impact, alongside positive, market rate, or outsized financial returns.
At first glance, the election of Donald Trump can seem a worst-case scenario. The President-elect’s stated support for the coal industry and withdrawal from the Paris climate agreement are policy positions that directly imperil the objectives of those advocating for the transition to a renewable energy-based economy. For those seeking to address growing wealth inequality, the prospects of tax cuts that benefit corporate interests and the ultra wealthy are worrisome in that they may reduce the provision of services to vulnerable communities. However, not all of Trump’s stated policy positions necessarily undermine the mission of those seeking to generate positive impact. A bright spot may be the outlook for the nation’s crumbling infrastructure, which the President-elect has presented as a priority.
Although the incoming administration’s unspecified tax reduction may seem at odds with the goal of funding infrastructure projects, there is opportunity to leverage a rare concentration of political power to mobilize significant amounts of impact capital through a new channel: the municipal bond market.
The historical source of more than 75 percent of infrastructure funding nation-wide, the $3.7 trillion municipal bond market represents a crucial financing tool for many thousands of issuers across the United States. But because the majority of municipal bonds are issued as tax-exempt securities, the market has traditionally lacked the attention of tax-exempt investors, including foundations and endowments.
In 2014, the assets of US foundations, colleges, and university endowments totalled nearly $1.4 trillion. Coincidentally, a 2016 report by the American Society of Civil Engineers estimated that the United States must invest $1.4 trillion between now and 2025—and $5.2 trillion by 2040—to close the country’s infrastructure spending gap. The implication, of course, is that non-traditional municipal investors represent a significant, largely untapped source of potential impact financing.
The potential for impact across the municipal landscape is vast. A 2016 report commissioned by HSBC estimated that only 32 percent of “climate-aligned” municipal bonds are designated as green bonds, and there is no such designation for socially impactful bonds. Therefore, if impact investors were to eliminate their dependence on the green bond label, they would find a far broader universe of investable opportunities. Municipal bond-financed projects often align directly with the missions and values of those seeking to serve the public good. By this standard, any impact investor should consider municipal securities, but especially scholarship and grant-making organizations.
After assuming control of the White House and Congress, the federal government’s infrastructure priorities will likely focus on transportation projects such as highways, railroads, and ports. Just as critical, however, are necessary improvements to educational infrastructure, resource conservation, affordable housing, health care, and urban revitalization. These issues are often tackled on the local and state level; they also align with the missions of many foundations and endowments. If the federal government intends to reduce its responsibility for addressing these issues, it could amend the tax code to incentivize investment in municipal bond-financed projects from non-traditional market participants.
When a taxable investor (a high-net-worth individual, for example) considers investing in a tax-exempt security, she must evaluate the investment in terms of taxable equivalent yield. Using her federal income tax bracket and state income tax rate (where applicable), she determines the value of the tax exemption to compare the investment across the universe of taxable alternatives.
However, a tax-exempt entity (such as a foundation or endowment) has no such income tax liability. In allocating to tax-exempt bonds, these entities would forfeit the value of the tax exemption, resulting in a concessionary return.
But there may be ways to monetize the value of this concessionary return and expand the market for municipal debt. An amendment to the tax code could allow private foundations, for example, to apply the value of the concession toward their five percent annual distribution (as required under Section 4942 of the Internal Revenue Code). A similar amendment could allow nonprofit university endowments to use the value of the concession to offset liabilities attached to taxable payouts, which could include scholarships.
In these ways, the incoming administration could directly incentivize investment in municipal debt from a large, historically under-invested pool of capital. This participation could pay enormous dividends in supporting impact-generating issuance, by enhancing the borrowing capacity of issuers across the board.
US households own the largest proportion of municipal debt. But because many of these investors tend to utilize long-term, buy-and-hold strategies, many issuers’ bonds are not actively traded. This leads to higher financing costs, especially for smaller issuers that come to market infrequently.
To illustrate the challenge, consider first the reality faced by a “general market” issuer, such as the San Francisco Public Utilities Commission (PUC). San Francisco PUC frequently brings large-scale financings to market; has a stable credit rating; and, because of the size of municipality’s investor base, has a significant amount of actively traded debt outstanding. These conditions lead to tighter bid-ask spreads and relatively efficient pricing.
But this is not the case for all—or even most—issuers. In New Mexico, where primary and secondary education is ranked among the poorest quality in the United States, for example, the Alamogordo Municipal School District has issued a series of bonds over the past eight years to improve educational infrastructure. These projects could be considered impact investments, yet according to Bloomberg data, these financings range from $1 million to $7 million each, and total a mere $32.5 million over that period. Because so few bonds exist—and trade—in the market, the school district must compensate investors for lesser liquidity, greater opacity, and the perception of higher risk associated with its debt. As a consequence, the district must sell bonds at a higher yield and spend more dollars on debt service instead of its potentially impactful projects.
By increasing demand through an expansion of the capital base, the new administration could encourage conditions that improve both market identification and price support for bond-funded projects like these. This would directly increase issuers’ capacity for financing new, ongoing, and future projects—many of which for-profit enterprises might never pursue.
Today, nonprofit entities can generate “additionality” by deploying impact capital to tax-exempt securities that otherwise would have been allocated across other asset classes. However, organizations that do so are typically the exception, rather than the rule.
Through amendments to the tax code, a large number of non-traditional municipal investors could become primary participants in an existing market that directly addresses social and environmental issues—and at a time when the federal government seems poised to abdicate some of this responsibility.
In providing liquidity for the municipal market, this additional demand could eventually translate into better impact disclosure, more robust reporting, and increased intentionality on the part of the issuing entities—inducing a virtuous cycle that contributes depth to the impact investing market.
Or, the opposite could occur.
At this unique point in history, it is critically important that impact investors of all types recognize the role that municipalities often play in generating positive social and environmental impact. With a greater appreciation of this impact, nonprofit entities could leverage their resources and access to policymakers to advocate for a larger and more inclusive market. In doing so, they can sustain and enhance a market that exists to serve the public good.