New research indicates that the US municipal bond market exhibits systemic mispricing of risk. Specifically, the pricing of municipal debt within this market fails to consider local physical climate risks, while simultaneously demanding higher credit spreads from communities with a greater proportion of Black residents. The study, conducted by Erika Smull and colleagues from Duke University, sheds light on these findings, which are presented in the open-access journal PLOS ONE on August 9.
Municipal governments across the United States issue municipal bonds to secure funding for various needs, such as education and infrastructure projects. The risk associated with investing in municipal debt depends on the distinct characteristics of each area, including socioeconomic factors and vulnerability to climate change. For instance, a coastal city facing the threat of rising sea levels may present higher investment risk, theoretically warranting a larger credit spread to compensate investors for the increased risk. However, limited research has explored the influence of climate risks on municipal debt pricing. Additionally, although some studies have suggested a connection between pricing and the racial demographics of issuing communities, this relationship has remained ambiguous. To address these gaps, the researchers analyzed data from over 700,000 municipal bonds to investigate the associations between pricing, climate risk, and race. The study focused on credit spreads, which reflect the difference between the interest rate paid to the bond buyer and a benchmark "risk-free" rate. A higher credit spread signifies greater perceived risk.
The statistical analysis revealed that bonds issued by communities with a larger proportion of Black residents tended to have larger credit spreads. This pattern amounted to an estimated annual cost penalty of $900 million across all Black Americans. This association persisted even after accounting for various economic and demographic factors. In contrast, there was no substantial correlation between heightened local physical climate risks and larger credit spreads for issued municipal bonds, suggesting that climate risks are currently not factored into the market's pricing. The study's findings suggest that the US municipal bond market exhibits mispricing of risk, disproportionately affecting Black Americans who already face greater climate change risks. The researchers highlight that the market imposes a "Black Tax," which cannot be explained by bond structure, ratings, or socioeconomic factors. Furthermore, the study underscores that climate risk is not adequately priced within the market, indicating an additional burden that communities of color bear in financing climate resilience efforts, even in the absence of explicit climate risk pricing signals.
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