Muni Bonds and Extreme Weather: 4 Ways to Help Protect Your Portfolio

If it seems like climate-related disasters are happening more often in the U.S., it's because they are. From 2016 through 2020, the number of such events that caused a billion dollars or more in damage averaged 16.2 annually—compared with just 7.1 annually from 1980 through 2020, according to the National Oceanic and Atmospheric Administration (see "Under the weather," below).

As a result, municipal bond investors shouldn't ignore the obvious: Natural disasters can have a financial impact on the municipalities in which they occur.

Let's take a look at how these disasters may affect muni-bond issuers, along with three steps investors can take to help protect their portfolios.

The threat from climate-related disasters isn't uniform across the entire $3.8 trillion muni market¹—leaving municipalities that are prone to droughts, floods, hurricanes, and wildfires at risk of increased expenses, lower revenues, or both. And yields don't appear to reflect such risks.

For example, consider two similarly rated airport revenue bonds—issued by Miami-Dade County and the City and County of Denver—both maturing at least 30 years from now. The risk of a severe weather event over the next three decades is much greater for Miami than it is for Denver, yet the yield to maturity for the two bonds is nearly identical. In other words, investors in Miami munis aren't being compensated for the region's greater weather-related risk.

For muni investors concerned about the potential impact of weather-related disasters, we suggest:

1. Diversifying geographically: If you invest in individual muni bonds, we recommend holding those from at least 10 issuers with different risks, including geographic. As a reminder, we suggest that most investors diversify their holdings nationally—with the possible exception of those in high-tax states such as California and New York, for whom in-state munis exempt from federal, state, and local taxes are particularly valuable.
2. Favoring higher-rated issuers: Issuers with sound finances generally have the flexibility to deal with surprises. New York City, for example, was able to maintain its AA credit rating in the wake of Hurricane Sandy, the fourth-costliest storm in U.S. history. New Orleans, on the other hand, was rated near the low end of the investment-grade spectrum even before Hurricane Katrina, the costliest storm on record, hit in 2005—and Standard & Poor's subsequently downgraded the city's general obligation (GO) bonds from BBB+ to a below-investment-grade rating of B. The city's GO bonds eventually rebounded to a rating of A+, but they took eight years to do so.²
3. Opting for shorter-term bonds: Weather events may lead to outmigration, which can result in a smaller tax base. After Hurricane Maria struck Puerto Rico in 2017, for example, the territory lost roughly 4% of its population to outmigration, pushing its population to a 40-year low.³ Focusing on short-term munis can help reduce this particular risk by limiting your exposure to potential population declines and other deteriorating conditions.

Overall, we recommend a mix of short- and intermediate-term munis to help ensure adequate diversification. However, we caution against lower-rated, longer-term munis in areas where weather shocks are more probable.