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Do Hurricanes Pose a Risk to the Muni Bond Market?

Key Points
  • The damage caused by natural disasters can put financial strains on municipal bond issuers. Issuers in good financial health should be better able to deal with the pressure.

  • Issuers in the affected areas that were already in a stronger financial position prior to the storm will be better positioned to respond to the financial challenges resulting from storm.

  • For investors concerned about the impact of natural disasters on their portfolio, we suggest diversifying among at least 10 different issuers with differing credit risks and sticking with higher-rated munis.

The combined cost of the destruction caused by Hurricanes Harvey and Irma is still being tallied, but there's little doubt these storms will rank among America's worst. We extend our sympathy to everyone affected by these disasters.

While there will be much to say about the broad human and economic impacts of these storms as the people of Texas, Florida and the Caribbean rebuild, we're going to keep our focus here on the consequences for the official bodies that issue municipal bonds. In particular, we'll be addressing concerns about whether the potential financial constraints created by the storms could increase risks in the muni market.

Potential effects

Looking at the entire muni market, we don’t think these storms increase risks across the board. The market appears to agree. Since the start of Hurricane Harvey, the yield for the broad muni market hasn’t changed,1 indicating that muni investors, on average, aren’t particularly concerned about an increase in risk.

Nor do they appear to be dumping bonds from issuers in Texas and Florida, two of the hardest hit states. One way to measure this is to compare the difference in yield between general obligation bonds from each state and a comparable AAA-rated general obligation index. If markets thought bonds from the storm-affected areas had grown riskier, then we would expect the spread in yields to widen as investors demanded more compensation for the increased risk. However, in both cases, spreads are still fairly close to their average levels for the year (though they have widened some in Texas since the storm arrived).

Spreads for 10-year Texas and Florida munis are near their averages for the year

The spread for the Texas 10-year GO index is now at 18.0 basis points, slightly above its average of 15.7 basis points. The spread for the Florida 10-year GO index is at 12.5, slightly above its average of 10.8 basis points.

Source: Bloomberg, as of 9/13/17. TheAAA-rated muni index is represented by the BVAL Muni Benchmark 10T Index, 10-year Texas GOs are represented by the 10-year component of the US Texas Muni BVAL Curve, and 10-year Florida GOs are represented by the 10-year component of the US Florida Muni BVAL Curve.

Issuers with better finances may fare better

Aid from the Federal Emergency Management Agency (FEMA) should eventually cover some of the costs associated with the cleanup and recovery. What matters to the issuers is how long it will take for any funds to be disbursed. If it takes a long time, issuers may have to pay for emergency services, rescue, debris removal and other costs using their own available funds.

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.2 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, we would expect issuers with more financial flexibility—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.

Standard & Poor’s looked at what effect the costliest most recent hurricanes had on municipal issuers to help determine the potential effect of Hurricanes Harvey and Irma. Prior to these recent storms, the three costliest hurricanes to strike the U.S. in recent history were Katrina in 2005, Sandy in 2012 and Ike in 2008, respectively. S&P found that issuers that ended up being downgraded because of the storms already faced financial challenges before the storms hit.

Before Hurricane Katrina hit, 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. In fact, the population of New Orleans is still below pre-storm levels. Following the storm New Orleans’ population dropped from 462,000 to 209,000 in 2006. It has since improved to 395,500.3 A shrinking population erodes an area’s taxable base, which can affect a muni issuer’s ability to pay bondholders.

Immediately following Hurricane Katrina, S&P placed the city of New Orleans 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 8 years to do so.

At the other end of the spectrum is Superstorm Sandy and New York City. Superstorm Sandy was the second 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.

A city’s ability to recover depends on its starting point

Source: S&P, as of 9/7/ 2017.

*Note: Credit rating for New Orleans, LA GOs after the storm is as of 11/16/05, as of 1/25/16 for New York City GOs, and as of 1/23/09 for Galveston, TX GOs.

The destruction caused by Hurricane Irma complicates Puerto Rico’s recovery

Puerto Rico definitely falls into the financially stressed category, which made the damage caused by Hurricane Irma particularly troubling. Its energy infrastructure took the biggest hit, according to Puerto Rico’s Governor. The commonwealth was already working to restructure its massive debt load and the storm is likely to complicate its recovery efforts.

In the short-term, FEMA aid should pay for the costs associated with recovery and clean-up, but if there’s a delay, the costs could fall on Puerto Rico, putting more pressure on its already strained financial situation. In the longer-term, the island could benefit from the increased economic activity associated with the recovery efforts, but out-migration could also add to the commonwealth’s woes.

Puerto Rico-backed bonds are speculative investments, in our view, and we do not currently recommend them for investors looking for a stable tax-exempt income in their muni portfolio.

Other concerns

Should muni investors be concerned about property and casualty insurance companies liquidating their muni holdings to help pay for claims? Property and casualty insurance companies often invest in municipal bonds because of their generally high and stable credit characteristics and tax benefits. If such investors liquidated their holdings, it would increase the supply of munis in the market and could cause prices of other outstanding munis to fall.

Historically, this hasn’t been a problem. As the table shows, only after Hurricane Irene did property and casualty insurance companies’ muni holdings shrink—though this likely had more to do with a drop in valuations than actual sales.

Property and casualty insurers generally have not sold munis to help pay for claims

Source: Municipal Market Advisors (MMA), as of August 2017.

What to do now

Unfortunately, Hurricanes Harvey and Irma are unlikely to be the last massive hurricanes or natural disasters to strike the U.S. 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-state. Also, consider diversifying among areas that are historically less prone to natural disasters. And remember, higher-rated muni issuers have historically had greater financial flexibility to respond to natural disasters.

1As represented by the change in the yield-to-worst of the Bloomberg Barclays Municipal Bond Index from 8/25/17 to 9/13/17.

2According to a 10/14/2016 City of Houston GO bond official statement.

3Source: S&P, as of 9/7/2017.

Next Steps

To discuss how this article might affect your investment decisions:

  • Call a bond specialist at Schwab anytime at 877-908-1072.
  • Talk to a Schwab Financial Consultant at your local branch.

Important Disclosures

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 or economic 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.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

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.

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

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Tax-exempt bonds are not necessarily suitable for all investors. 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. 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.

BVAL Muni Benchmark 10T Index: The curve is the baseline curve for BVAL tax-exempt munis. It is populated with high quality US municipal bonds with an average rating of AAA from Moody's and S&P. The yield curve is built using non-parametric fit of market data obtained from the Municipal Securities Rulemaking Board, new issues calendars and other proprietary contributed prices. Represents 5% couponing.

US Texas Muni BVAL Yield Curve 10 Year: The yield curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL  curve is populated with US General Obligation municipal bonds issued by the State of Texas.

US Florida Muni BVAL Yield Curve 10 Year: The yield curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with US General Obligation municipal bonds issued by the State of Florida.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Barclays U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.

(0917-7VE7)

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