Climate, race, and the cost of capital in the municipal bond market

Abstract

Both climate risk and race are factors that may affect municipal bond yields, yet each has received relatively limited empirical research attention. We analyzed > 712,000 municipal bonds representing nearly 2 trillion USD in par outstanding, focusing on credit spread or the difference between a debt issuer’s interest cost to borrow and a benchmark “risk-free” municipal rate. The relationship between credit spread and physical climate risk is significant and slightly positive, yet the coefficient indicates no meaningful spread penalty for increased physical climate risk. We also find that racial composition (the percent of a community that is Black) explains a statistically significant and meaningful portion of municipal credit spreads, even after controlling for a variety of variables in domains such as geographic location of issuer, bond structure (e.g., bond maturity), credit rating, and non-race economic variables (e.g., per capita income). Assuming 4 trillion USD in annual outstanding par across the entire municipal market, and weighting each issuer by its percent Black, an estimated 19 basis point (bp) penalty for Black Americans sums to approximately 900 million USD annually in aggregate. Our combined findings indicate a systemic mispricing of risk in the municipal bond market, where race impacts the cost of capital, and climate does not.

Impact of Flooding and Drought Risks on the Cost of Bond Financing for Water Utilities

“…24 The caveat with using survey data on climate change perception is that they reflect the overall views of residents within a county and does not specifically represent the perspectives of municipal bond investors. 49 Water consumption and public perception both demonstrate a moderating effect on the water risk premium in bond pricing. Counties with higher water consumption show a stronger bond premium response to flood and drought risks.…”

“…Additionally, we rely on perception of climate change as a proxy for volatility, a methodology in line with previous studies . The caveat with using survey data on climate change perception is that they reflect the overall views of residents within a county and does not specifically represent the perspectives of municipal bond investors …”

Research to Confront Climate Change Complexity: Intersectionality, Integration, and Innovative Governance

“…They are likely also balancing multi-level financial and political considerations, including maintenance of their local tax base and municipal financial ratings, shrinking access to insurance, divergences in resident preferences, legal risks from declines in government services, and the legacy challenges of their broader socioeconomic context (Kousky, 2022;Ruppert et al, 2019;Shi et al, 2023;Smull et al, 2022). The options available to the municipality depend on wide-ranging interactions across the behaviors of individual households, the institutions and markets shaping investments, and the local-to-global policy landscape (Berrang-Ford et al, 2021;Hallegatte et al, 2016;Moore et al, 2022;Smull et al, 2023). When the next climate-related disaster strikes, should the town and its residents prioritize rebuilding, ideally more safely, in this increasingly perilous place, or should it try something radically new, such as merging with another local government and encouraging relocation to a safer area (Hallegatte et al, 2016;Mach & Siders, 2021)?…”

The proliferation of municipal green bonds in Africa and Latin America: the need for a climate justice approach

“…Loftus et al (2022), Eldemire et al (2022) and Smull et al (2022) findings were discussed at the 11th Annual Municipal Finance Conference organized by the Brookings Institution (Brookings Office of Communications, n.d. ).…”

“… 86. In summary, they conclude, there is “a systemic mispricing of risk in the municipal bond market, where race impacts the cost of capital, and climate does not” (Smull et al, 2022, page 1). …”