The disclosure gap across the municipal bond industry needs further tightening and it's time to think about the ineffectiveness of "boilerplate language" assigned to specific risk exposures.
A sense of urgency can be felt among many investors, who want more transparency about the financial resources available to address the more frequent occurrence and increased magnitude of natural catastrophes with more costly human and financial devastation, along with the heightening of risk related to climate change and cybersecurity threats.
As subject matter experts and gatekeepers to a municipal securities transaction, these comments are directed toward the legal community given their role in the securities law and regulation space. My thoughts are meant to engage, elicit feedback, and inspire active dialogue. This is by no means the final word, but simply the start of a mutually beneficial conversation.
Institutional investors have argued for the inclusion of stronger transparency and disclosure in offering documents, and it is quite reasonable to expect more defined standards from bond attorneys, complementing activist participation from public finance professionals. This discussion deserves focus from bond attorneys to ensure stakeholder compliance with their disclosure obligations, to mitigate potential disclosure risks for inadequate information, and to preserve investor confidence essential to making informed capital commitment decisions.
Muni participants generally agree that disclosure in the $4.3 trillion market has materially improved since the 1989 and 1994 adoption of SEC rule 15c2-12 for both primary and secondary market requirements respectively. Organizations including NABL, GFOA, MSRB, NASBO, NCSL and NFMA work together to deliver uniform disclosure standards, but more is needed to capture evolving events with long-term consequences.
Throughout the past three decades, financial markets have witnessed life-changing occurrences that included the 9/11 terrorist attacks, a broad-based financial crisis, the COVID-19 pandemic and multiple natural catastrophes. ESG considerations and cyber-threats are increasingly part of the investment narrative. Bond disclosures continue to improve regarding climate conditions and remediation, yet transparency remains uneven and even lacking at times.
"Labeling" has yet to produce meaningful cost benefits across the issuer universe. It has been suggested that perhaps muni issuers need to go beyond the ESG label and develop a comprehensive branding campaign that offers extensive project-specific marketing that touts economic accretion and societal benefits to capture market interest and to cultivate demand for this type of bond cohort. This would likely generate additional disclosure needs.
The market should do a better job pricing climate change risks. Technical muni market conditions have the tendency to mute credit and pricing distinctions, but elevated scrutiny over catastrophic risk on the heels of the Texas flooding and the L.A. wildfires, for example, were viewed to have potential implications for certain security types, such as school districts, local governments and smaller obligors from compromised geographic locations. Should spread distinctions emerge, mutual funds, which are often forced buyers or sellers, may be less discerning. However, expanding SMAs are more likely to leverage ESG spread variances and capture return given their ability to be more flexible.
Climate change risks are receiving greater scrutiny, and we are seeing a broadening application of bond proceeds to combat these risks. The risks associated with wildfires and hurricanes are gaining attention with certain issuers altering their capital plans. The Federal Reserve has identified climate change as an ongoing threat to the U.S. economy with policymakers voicing their concern over wealth destruction, a further distortion of existing income inequalities, and even the potential for a permanent displacement of area residents. Federal and state policies that are crafted to mitigate climate change are likely to impact prices, productivity, employment, and output with potential implications for monetary policy. Issuers should develop stress tests to account for such impact, with relevant counsel providing disclosure guidelines.
I am also mindful that issuers must balance their own mandates against the legal and political complexities underlying this hotly debated subject. This is another area where better disclosure could be constructive. Should FEMA be altered in any way that dilutes its presence and significance, or becomes subject to a complete dismantling, state and local governments could be burdened by costly recovery efforts, placing downward credit pressure upon those affected issuers.
Cyber security concerns are a growing investment consideration. Municipal governments and their enterprise units must expand their disclosure surrounding their preparedness for this critical threat. The risks to municipal credits are rising, especially where cyberattacks are fueled by financial gains. This represents a threat to national security that could gravely disrupt our nation's financial system, array of infrastructure assets, health care delivery protocols, communication and information technology networks, and the security of our food stock.
There have been various instances of cyberattacks targeting
Enhanced cybersecurity responses and preventative measures along with a broader use of insurance do help to insulate financial and operational exposure for municipal issuers, but the growing expenses associated with insurance premiums and such preventative and remedial actions add budgetary pressure for many obligors. Again, the current policy environment does not foster a streamlining of available federal resources and prohibitions against paying ransom in various states have yet to offer conclusive evidence that such bans are effective. This represents an area where legal guidance can be very effective.
Investors need to evaluate the reliability of information presented in the offering documents and they need to have a better understanding of how various insurance policies work when triggered. Clarity over the appropriate sizing of the policies and how an issuer can implement mechanisms to offset shortfalls must be disclosed. Issuers may also see higher deductibles and smaller reimbursement rates, and such revisions need to be disclosed.
These considerations are by no means exhaustive, but they do represent key areas where improved disclosure can provide benefits. Logically, the adoption of new disclosure standards can dovetail with existing 15c2-12 practices, with more precise methodology for ESG and cyber security presentations part of primary market disclosure, and additions to material event notifications incorporated into secondary market releases.
