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Is Climate Change a Risk to the Muni Market?

Although the year isn’t over yet, 2019 is the fifth consecutive year during which 10 or more billion-dollar weather and climate disasters have occurred in the United States. Worse, these disasters have resulted in the deaths of 39 people.1

While we don’t want to minimize the human toll, and we’re well aware that climate change has become a hot-button issue, municipal bond investors can’t ignore the fact that natural disasters such as hurricanes, floods, wildfires and drought have a major financial impact on the areas in which they occur.

Also, regardless of one’s opinion about the role of climate change, the facts show that billion-dollar weather and climate events are occurring at an increasing rate: According to NOAA, the 1980-2018 annual average was 6.3 events (adjusted for inflation based on the Consumer Price Index, or CPI), while the annual average for the most recent five years (2014-2018) was 12.6 events (CPI-adjusted).1

Leaving aside the question of why the pace of natural disasters has been accelerating, we will take a look below at how climate and weather disasters may affect issuers in the municipal bond market, along with five steps investors can take to protect their portfolios.

Historically, the muni market has been resilient despite major natural disasters

Source: Bloomberg Barclays Municipal Bond Index, as of 10/28/2019. Disasters were selected because they had an estimated cost greater than $10 billion, according to the NOAA National Centers for Environmental Information (NCEI). Past performance is no guarantee of future results.

 

A growing focus on climate risk

Climate risk isn’t new, but the idea of incorporating it in the municipal bond market is still in its infancy. Moody’s and S&P don’t explicitly incorporate climate risk into credit ratings, but there has been a heightened focus on the issue. For example, Moody’s recently acquired a majority stake in Four Twenty Seven, a California-based climate risk data firm,2 suggesting it may move toward incorporating climate risk into its bond ratings. Although the ratings agencies currently don’t explicitly factor climate risk into ratings, they do incorporate it in other ways—for example, they consider the risks an issuer faces and the steps it's taking to help moderate those risks.

Yields for muni bonds don’t appear to incorporate the risk of climate change yet, either. To illustrate, we compared two similarly rated airport system revenue bonds, both maturing at least 30 years from now. One was from Miami-Dade County, Florida, and the other was from Denver, Colorado. The risk of a climate shock, such as a hurricane or flooding, over the next 30 years is arguably much greater for Miami than for Denver. However, yields for the two bonds were nearly identical. In other words, investors weren’t getting higher yields for the potential risk of climate shock in this scenario (caveat: This is just one example in a market that has $3.6 trillion bonds outstanding). 

Mitigating factors for muni yields

There are many possible reasons why yields for munis may not be reflecting climate risks. One is that when the president or a state governor declares a disaster, it opens up a wide range of assistance programs for local governments. The Federal Emergency Management Agency (FEMA), for example, provides a minimum of 75% of the cost of cleanup and restoration.

However, 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. For example, when Hurricane Ike struck the Houston area in 2008, then-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. 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, which was eventually reimbursed with FEMA funds.

Why climate risk matters

We don’t believe climate and weather pose a major risk to the muni market as a whole, but we do think it will affect some issuers to varying degrees. For a municipality, a hurricane, flood, or drought could result in lost revenues, damaged infrastructure, economic disruption, and outmigration, among other issues. These are all problems that could lead to lower revenues, increased expenses, or a combination of both. Unlike other bond issuers, such as corporations, muni issuers generally can’t shift operations to mitigate the impact.

Trying to alleviate the impact of climate change also can increase liabilities for muni bond issuers, resulting in less financial flexibility to meet debt service.

What to consider now

For muni bond investors who are concerned about the potential impact of climate risk, we suggest the following:

1. Diversify geographically

 If you’re investing in individual bonds, we recommend holding bonds from at least 10 different issuers with differing credit risks. This includes issuers in different locations. As a reminder, we recommend that most investors in all states, other than New York and California, diversify nationally.

2. Choose areas that are less likely to be affected by climate shocks

It’s no surprise, but location matters. Areas like the Midwest are more likely to be affected by extreme heat, whereas coastal areas are more likely to be affected by sea level rise. We don’t advocate avoiding issuers in these areas completely, but be cognizant of the risks when you are looking at issuers there.

3. Focus on higher-rated issuers and do additional due diligence

Historically, issuers with more financial flexibility—a quality that is often associated with higher credit ratings—have been better able to manage through the financial disruption of climate and weather shocks. Muni issuers whose finances already were 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 – which is below investment grade. 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 coastlines of New Jersey and New York, 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.

4. Consider issuers whose revenues are less likely to be affected by climate and weather shocks

In general, states tend to have diverse revenue streams, and have historically been less financially affected by climate shocks than other muni issuers.

However, revenue bonds—which are typically repaid from the issuer’s revenues—are more likely to be affected. An example of a revenue bond issuer would include a water and sewer facility, an airport, a college, or a not-for-profit hospital. 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 to the area. The airport’s credit rating has since recovered, and the bond are rated A- by S&P.

Broadly speaking, we believe that business-like enterprises such as these are at a greater risk than a state government from the financial impacts caused by a natural disaster.

5. Focus on shorter-term bonds

Since Hurricane Maria struck Puerto Rico in 2017, the territory has lost roughly 4% of its population to outmigration.3 Over time, a declining population can result in a smaller tax base. Population trends often take years to develop, so a focus on short-term munis can help reduce this risk. We currently recommend an average duration of five to eight years in a muni portfolio, which means having some short-term and some longer-term munis. Be cautious with longer-term munis that are lower-rated and whose issuers are in areas where climate shocks are probable.

Unfortunately, climate shocks like hurricanes, floods and wildfires, are going to continue. However, muni investors can take steps to lessen the risk on their portfolios. If you need help selecting the right investments to potentially reach your goals, a Schwab Financial Consultant can help.

 

¹ NOAA National Centers for Environmental Information (NCEI), U.S. Billion-Dollar Weather and Climate Disasters (2019), as of October 9, 2019, www.ncdc.noaa.gov/billions/

2 Moody’s Corp., “Moody’s Acquires Majority Stake in Four Twenty Seven, Inc., a Leader in Climate Data and Risk Analysis,” July 24, 2019.

3 Pew Research Center, “Puerto Rico’s population declined sharply after hurricanes Maria and Irma,” July 26, 2019.

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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.

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

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