The increasing number of natural disasters have reignited the conversation about the financial impact of extreme weather on the municipal bond market. While the effects can be unique on each municipality, the following provides more detail on broader ramifications of such events
Rising financial costs of weather related disasters
In recent years, weather disasters have caused severe life and property damage raising concern about rising costs of such events. Financial costs related to wildfires and hurricanes have exponentially increased over the years with 2019 marking the ninth consecutive year with eight or more billion dollar disasters. The cumulative cost of weather events in 2017 alone was $306 billion, breaking the previous record of $214 billion in 2015.1 The magnitude of such events has been greatly exacerbated by extreme weather conditions including rising sea-levels, higher temperatures, and severe drought conditions. The frequency and severity of weather events has increased over the years, exposing municipal bonds to economic losses across sectors and geographic regions.
Impact of extreme weather events on municipal credits
Natural disasters like wildfires, hurricanes, flooding and other extreme weather events can have an adverse impact on communities, presenting a multitude of challenges including economic disruption, infrastructure damage, and high restoration costs.
Economic impact could be magnified for some communities as a result of population loss, reduced property valuation, lower tax revenues, depletion of liquidity, and reduced tourism that may lead to a slow recovery. On the other hand, some communities have reported improved economic growth after such events due to increased spending from rebuilding and renovation activities.
Credit impact of extreme weather events has been muted due to very strong federal, state and local support, but this is not always the case. One extreme example was the 2018 Camp Fire in California that has had a more devastating effect on smaller communities like the Town of Paradise. Its population contracted to only 10% of its pre-disaster size leading to a very small tax base.2
Economic recovery can be slower for communities with a smaller tax base and population due to a number of factors including limited financial resources to rebuild, delays in federal and state aid, sizable job losses leading to population outflow, and sometimes a lower appetite of residents to rebuild. Larger communities tend to be more economically significant and have broader resources available leading to a faster recovery. One example would be the city of Houston that was impacted by Hurricane Harvey in 2017. Harvey caused significant life and property loss in the area and the city faced risk of high unbudgeted costs from flood control and restoration.
The city was able to recover rapidly due to availability of broad resources from federal funds and its internal liquidity. Recent property assessment records show that the city’s tax base has fully recovered to pre-Harvey level. Sales tax and other governmental revenues have also recovered with strong projected growth due to the city’s stable population and continued business investment. Diversified communities with larger resources and a broader economic base tend to rebuild faster, which helps them better withstand sustained credit deterioration.
Reimbursement for damages
The majority of disaster relief money comes from FEMA (Federal Emergency Management Agency), the federal government’s disaster management agency. When a state of emergency is declared during a disaster, federal aid is diverted to the affected areas with little need for approval. Short-term financing for disaster relief usually comes from a combination of state and local sources. For states like California, Texas, Florida, Louisiana and the Carolinas that have experienced weather-related events, large cash reserves at the state or local level help bridge financing gaps. An important consideration: the capability to levy taxes and charge for essential services lets municipalities build reserve funds in preparation for situations like natural disasters.
States that experience higher frequency of extreme weather events may provide additional support to municipalities by providing revenue relief. For example, California backfills lost property taxes for municipalities impacted by wildfires. In the case of Butte and Lake Counties that were impacted by Camp Fire in 2018, the state committed to backfill up to three years of property taxes associated with fire losses, lessening the negative credit impact.
Municipalities have an extremely strong track record of recovering from natural disasters without bondholder impairment. In fact, Moody’s and S&P have both stated that none of their rated bonds have ever defaulted due to a natural disaster. The immediate disaster disruptions tend to cause short-term liquidity problems, which are often subsequently remediated by federal aid, state support, insurance payments, and private charitable donations. Additionally, many governments have experienced increased sales tax revenues as rebuilding occurs. An integral part of the credit research framework is assessing the depth and breadth of resources available to support a municipal bond should an unforeseen negative event occur.
Municipal credit analysis and extreme weather related events
Municipalities with fewer resources might experience the short term effects of a natural disaster more acutely than larger, more affluent municipalities. However, in most cases long-term economic impact can be muted due to strong state and federal support.
Although the historical impact of extreme weather events has had limited impact on the creditworthiness of municipal bonds, higher frequency could put a strain on resources. Weather related risks cannot be completely eliminated but can be mitigated.
A strong municipal credit selection process should focus on identifying municipalities with diversified tax bases, economies, and broad financial resources available to help withstand an unforeseen event. Financial resource analysis should not be limited to a municipality’s internal liquidity but also includes history of disaster aid by federal and state sources, private fundraising, and insurance coverage carried by the municipality and residents, and in some instances the political environment. Strong state support can be a mitigating factor to some weather related events. States that have stronger economies and higher fund balances tend to provide supplemental support to municipalities that could help replenish liquidity and attempt to mitigate lost tax revenues, which lessens credit impact.
Diversifying portfolios on a sector and state level may help to mitigate credit risks. Investing in a wide range of municipal sectors and geographies within a state exposes an investor to different revenue streams and areas within the state. Such revenue streams and geographic areas are impacted differently during a catastrophic event. Limiting portfolio exposure to certain issuers that are in high risk areas that have a higher probability of experiencing recurring natural disasters may also help reduce risk.
In summary, municipal defaults from extreme weather events have been rare but higher frequency of such events could have adverse effects on municipal creditworthiness. Risks may be mitigated by identifying higher quality municipal bonds that have broader available resources to withstand credit deterioration and manage exposure on a state and sector level.