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

November 18, 2021 Cooper Howard
Some municipalities are more susceptible to weather-related risk than others. Here's how to help weather-proof your muni 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.

Uneven effects

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.

Under the weather

The number of billion-dollar weather events hit a record high in 2020.

In 2015, there were a total of 11 weather events that caused a billion dollars or more in damage. By 2020, that number had increased to 22 events—a 100% increase.

Source: National Oceanic and Atmospheric Administration.

How to respond

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.

Mix it up

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.

1Bloomberg, as of 09/07/2021.

2Bloomberg, as of 06/30/2021.

3Antonio Flores and Jens Manuel Krogstad, "Puerto Rico's population declined sharply after hurricanes Maria and Irma," pewresearch.org, 07/26/2019.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Diversification strategies do not ensure a profit and cannot protect against losses in a declining market.

Investing involves risk, including loss of principal.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

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