In general, we don’t believe natural disasters pose a significant risk to municipal bond issuers, unless the municipality was directly affected by the disaster and lacks adequate resources.
No state or local government rated by Moody’s Investors Service has ever defaulted on its bonds due to a natural disaster, but downgrades are a possibility.
Investors who are worried about the potential impact of natural disasters should consider diversifying among at least 10 different issuers with differing credit risks and sticking with higher-rated munis.
The United States experienced 16 separate billion-dollar natural disasters in 2017, including three Category-4 hurricanes, inland floods, a crop freeze, drought and wildfires.¹ The cumulative damage of these events exceeded $300 billion. So far, 2018 has brought multiple such disasters, including two major winter storms, wildfires in California and Hurricane Florence along the East Coast.
We extend our sympathy to everyone affected by these catastrophes, whose human impact overwhelms all other considerations. The effect on communities can be devastating, and we hope they are able to rebuild quickly.
At the same time, we have heard from some investors wondering if they should avoid municipal bonds issued by states or local governments grappling with a recent natural disaster. Our answer is no, unless the bond is issued by a municipality that is directly affected by the disaster and doesn’t have adequate resources.
Historically, most municipal issuers affected by natural disasters have been able to manage through the financial impact caused by the disaster. No state or local government rated by Moody’s Investors Service has defaulted on its bonds due to a natural disaster, but downgrades are a possibility (when a bond is downgraded, its price generally falls). In general, we don’t think natural disasters pose a risk to the broad muni market, or to bonds issued by states that are prone to natural disaster. However, they could have an impact on more regionalized issuers.
Disasters historically haven’t affected the broad market
Natural disasters don’t appear to pose a risk to the broad muni market, as we haven’t seen yields rise across the board following past natural disasters. Higher yields would mean that muni investors, on average, are more concerned about the increased risks. But historically yields have been relatively unchanged following a major natural disaster.
The broad muni market has been resilient with past natural disasters
Source: Bloomberg Barclays Municipal Bond Index, as of 9/12/2018. Disasters were selected because they had an estimated cost greater than $10 billion according to the NOAA National Centers for Environmental Information (NCEI).
Another way to measure whether natural disasters pose a risk to the bonds of states most affected by disasters is to compare the yield for a broad index of state-issued munis compared with an index of AAA-rated munis, which have very low default risk. Historically, the difference in yields—or the spread—for bonds issued by states most affected by natural disasters also haven’t changed much following the disaster. If investors believe bonds from storm-affected areas have grown riskier, then spreads should widen as they demand more compensation for the increased risk.
This isn’t surprising to us, because states have very diverse revenue streams that aren’t significantly affected by atypical events. Payments on bonds account for less than 5% of states’ revenues on average,² so even if there is a financial disruption states generally have enough financial flexibility and financial reserves to meet debt service. As of the time of this writing, trading in bonds issued by North Carolina and South Carolina has been limited and prices are little changed, despite the impact of Hurricane Florence.
Payments on bonds generally account for a small portion of state revenues
Debt service ratio based on fiscal year 2016 own-source* revenues
Source: Source: Moody’s Investors Service, as of 4/24/2018.
“Debt service” reflects debt service costs (usually interest and principal) as a percentage of own-source governmental revenues.
Note: Additional adjustments have been made by Moody’s to own-source revenues for Delaware, Massachusetts and Washington to reflect inclusion or exclusion of certain funds.
*“Own-source revenues” excludes items such as transfers from the federal government.
Higher-rated local governments generally should be able to manage
Bonds issued by cities or counties are more likely to be affected, because their revenue streams generally are not as diverse as state revenue streams. Issuers with greater financial flexibility—which is often indicated by a higher credit rating—generally are able to better manage the financial disruptions caused by the disaster. Ratings, however, are subject to change over time.
In the short term, aid from state or federal programs, such as the Federal Emergency Management Agency (FEMA), should cover some of the costs associated with the cleanup and recovery. If there is a delay in receiving aid, city and county issuers may have to pay for emergency services, rescue, debris removal and other costs using their own available funds, which could affect their credit quality.
To cite a recent example of how this might work, when Hurricane Ike struck the Houston area in 2008, President George W. Bush issued an emergency declaration that immediately made federal assistance available to cover 100% of the city’s eligible costs incurred in providing shelter and care to victims of the hurricane.³ Before receiving any aid, the city created the Hurricane Ike Aid and Recovery Fund to track and record all expenses related to the relief effort. Initially, the recovery fund was funded with money from the city’s rainy-day fund, but was eventually reimbursed with FEMA funds.
Should that be the case after the most recent storms on the East Coast, we would expect issuers with more financial flexibility—again, a quality that is often associated with higher credit ratings—to be better placed to deal with such costs. Muni issuers whose finances were already under pressure, which are usually already lower-rated, may be at risk of downgrades—and therefore price declines—because of the added strain. When a bond is downgraded, it reflects the opinion of the credit rating agency that the issuer has less financial flexibility to meet its debt service.
For example, before Hurricane Katrina hit in 2005, New Orleans had already been struggling financially and was rated BBB+ by S&P—near the low end of the investment-grade spectrum. The storm devastated the city and caused massive damage from which the city took years to recover. Immediately following Hurricane Katrina, S&P placed the city of New Orleans general obligation (GO) bonds and several area issuers on credit watch in expectation of a decline in revenues. Approximately two months after Katrina, S&P downgraded many New Orleans issuers, including the GO debt, to B. The credit rating for the city’s GO bonds has since recovered to AA-, but it took eight years to do so.
At the other end of the spectrum is Hurricane Sandy’s impact on New York City in 2012. Sandy was the fourth-costliest storm in U.S. history. Although there was substantial damage along the coastline of New Jersey, there was little financial impact on New York City, the economic hub of the region. Due to the city’s already strong financial position, as indicated by its AA credit rating at the time, it could more easily respond to the negative impact from the storm. The city’s credit rating was unchanged following the storm.
An issuer’s ability to recover largely depends on its starting point
Source: S&P, as of 9/14/2018.
Note: Credit rating for New Orleans, LA GOs after the storm is as of 11/16/2005, as of 1/25/2016 for New York City GOs, as of 1/23/2009 for Galveston, TX GOs, as of 2/23/2018 for Sonoma County pension obligation bonds (POBs), as of 9/14/2018 for Napa County certificates of participation (COPs), and 1/18/2018 for Houston, TX GOs.
Revenue bonds may be more affected
Revenue bonds are a type of municipal bond issued by an entity that earns revenues from more business-like operations to pay their bonds back. An example would include a water and sewer facility, an airport, a college, or a not-for-profit hospital. Broadly speaking, we think that business-like enterprises are at a greater risk than a state or local government from the financial impacts caused by a natural disaster.
If the disaster causes a slowdown in economic activity, revenues could decline for issuers in the affected areas. For example, following Hurricane Katrina, S&P lowered the rating on Louis Armstrong New Orleans International Airport’s general airport revenue bonds to BB from A because of a “dramatic drop” in passenger traffic and uncertainty regarding future demand for airline travel in the area. The airport’s credit rating has since recovered and the bond are rated A- by S&P.
Some revenue bonds contain provisions that allow them to be redeemed early, using private insurance proceeds, due to damage, destruction or condemnation of the property. The bonds are generally “called” (or redeemed) at par or above, but it may still result in a loss for investors who bought them at a price greater than their call price. Investors in individual bonds can review the bonds’ offering statements on schwab.com, or call a Schwab fixed income specialist to determine if extraordinary provisions exist for their bonds, and the details.
Outmigration due to natural disasters is a risk over the longer term
At the simplest level, the demographics and economics of a region affect the credit quality of an issuer. Issuers located in areas with steadily increasing populations, relatively skilled workforces and diverse industries generally have greater financial flexibility, which results in higher credit ratings. Natural disasters could result in outmigration from the affected area, because the emotional and financial costs for residents to rebuild may be too high. Over time this could negatively affect economic activity or property values, resulting in lower revenues for issuers in the affected areas. Consider avoiding munis with very long maturities to help mitigate this risk.
What to do now
Unfortunately, Hurricane Florence and the wildfires in California this summer are unlikely to be the last natural disasters to strike the United States. Because it’s impossible to predict when disaster might strike, we think muni investors should manage their risks through diversification and a focus on high-quality bonds.
We suggest muni investors diversify among at least 10 different issuers with different credit risks—even if they are investing in in-state bonds. Also, consider diversifying across areas that historically have been less prone to natural disasters. And remember, higher-rated muni issuers have historically had greater financial flexibility to respond to natural disasters.
1 Source: NOAA National Centers for Environmental Information (NCEI) U.S. Billion-Dollar Weather and Climate Disasters (2018).
2 Source: Moody’s Investors Services, as of April 24, 2018. Represents the simple average of all 50 states.
3 According to a 10/14/2016 City of Houston general obligation bond official statement.
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.