Mission, Money & Markets: Municipal bonds and the trend toward social justice
By Kimberlee Cornett and Napoleon Wallace
Back in 1812, the municipal bond market was born when the City of New York issued the first recorded municipal bond for a public purpose canal. Since this first issuance, community impact has been central to this market.
Municipal bonds are debt securities issued by a state, county, city or municipal district to finance capital expenditures – from the canals of the past to the schools, public facilities, mass transit systems and affordable housing developments of today. This market issues more than 13,000 bonds annually to undergird the operations and infrastructure of nearly 44,000 municipalities and other districts. Together, it accounts for $3.7 trillion in total debt and more than $400 billion flowing into American communities each year, according to Bond Buyer.
The scale, scope, and public focus of this market has led us to ask: How does the municipal bond market intersect with The Kresge Foundation’s mission to create opportunities for low-income people in American’s cities? And how might we influence the market to put greater consideration on the long-term impact of socioeconomic characteristics, such as income inequality, on the fiscal outcomes of cities?
Today, there are a few socially-focused municipal bond funds and related initiatives gaining traction, such as the Calvert Tax-Free Responsible Impact Bond Fund, Columbia US Social Bond Fund, HIP Investor’s Ratings on Neighborly.com, and Activest. However, the municipal market has historically had a weak and under-developed lens on non-financial factors such as social outcomes. The reason is simple – like most capital markets, the municipal bond market is driven by risk, and municipal risk assessment is largely driven by the bond ratings agencies. Both agencies (S&P and Moody’s) weigh the locality’s economy at 30 percent of their assessment; they carefully considering the size, diversity, and strength of a local government’s tax base and its ability to generate revenue through property, sales and income tax. The remaining risk factors include management, budgetary performance and flexibility, and contingent liabilities such as pension obligations.
What is less present in many of the current risk frameworks is how socioeconomic factors – things like poverty levels, income inequality, availability of affordable housing, employment base diversity, political and philanthropic leadership and civic engagement – are considered as future potential risks. For instance, when income inequality grows, it negatively affects most, if not all, of the abovementioned ratings attributes. Such factors could significantly impact the long-term fiscal and operational soundness of a municipality. This is especially true given the backdrop of tightening city budgets, widening income inequality and burgeoning unfunded pension obligations that have left many cities cash-strapped with few short-term incentives – or resources – to invest in developing healthy, productive people and places for citizens of all income levels to work, live and play.
The City of Ferguson, Missouri provides a clear case study for this issue. Many are familiar with the well-publicized fate of Michael Brown and Ferguson -- the officer-involved shooting, the social unrest, and the Department of Justice Investigation. But what is less known is the city’s fiscal story. In 2004, Ferguson was not a household name. It was just a large-city suburb with a declining population, diminishing economic activity and a dwindling tax base. Between 2000 and 2012, Ferguson’s poverty rate doubled with roughly one in four residents living below the federal poverty line, according to the Brookings Institution. In response to this fiscal predicament, Ferguson city council approved and erected a revenue-focused policing effort to offset the city’s declining tax base.
Fiscally, this decision produced revenue for the city. But civically, this action ultimately had a profound impact on community trust, putting revenue generation ahead of genuine public safety and community relations. By December 2013, 20 percent of Ferguson’s $12.8 million budget was funded through fines, fees, and related revenue, accord to the DOJ. The short-sighted decision to pursue non-recurring, high-risk revenue eventually contributed to frayed civic trust, Michael Brown’s death, and months of civil unrest. This led to a precipitous decline in Ferguson’s general obligation bonds and limited the city’s ongoing ability to fund capital improvements and operations. Currently, Ferguson’s 3 percent general obligation bonds, which were issued in 2011 and were priced at approximately $1,000 per bond, now trade at approximately $565 per bond with a yield of almost 10 percent. Over this same period, Moody’s downgraded the city’s credit rating from high-grade to junk bond status.
At the same time, we see examples of cites approaching issues of income inequity, poverty and environmental risks more thoughtfully by targeting “upstream” solutions, and interestingly, issuing bonds that directly fund quality of life improvements for residents. For instance:
DC Water’s Environmental Impact Bond (EIB) will fund the construction of green infrastructure to absorb storm water surges and prevent the overflow of untreated sewage into area rivers. This is a clear example of how city leaders can use the bond market to finance investments that have a greater impact on seemingly intractable problems, such as decaying municipal infrastructure.
In late 2016, the Seattle City Council approved the issuance of $29 million in limited tax general obligation bonds, as part of its larger Under One Roof initiative, to help enable the development an estimated 600 apartments for households earning less than 60 percent of median income.
In Philadelphia, city leadership and council recently approved the issuance of a $100 million bond to fund the expansion of existing home maintenance and repair programs for low-income homeowners.
Issuers and investors have yet to agree on the benefits both could experience through the use of a more comprehensive risk framework, such as an appropriate risk-adjusted return for investors and a more fair cost of capital for issuers. However, as more examples emerge of upstream, bond-funded, civic investments, we expect that smart cities, investors, and perhaps even rating agencies, will come to see the fiscal value in making investments that grow living wage jobs, facilitate the development of affordable housing, invest in workforce development and actively pursue the alleviation poverty. Further, we believe that this market transition could present some very impactful social investment opportunities.
We believe the cities that pursue these kinds of investments will also make smarter choices elsewhere, such as effectively managing long-term pension obligations and improving the interoperability of their departments to inform decision-making, which will lead to the longer-term viability of their cities, communities and credits. These investments and choices are not only the right thing to do from an urban opportunity perspective, but in many places, these are the right investments to make out of economic necessity for the future. In 2017, our Social Investment Practice looks to learn, test our assumptions and invest in places, communities and people making smart investments that we think will pay dividends over time.
Kimberlee Cornett is the managing director for the foundation's Social Investment Practice. Follow her on Twitter @kr_cornett. Napolean Wallace is a social investment officer who works primarily with the Health and Human Services team. Follow him at @NapoleonWallace. Follow the Social Investment team @kresgesocinv.