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California Wildfires and the Impact on Municipal Bond Creditworthiness

Recent wildfires in California have reignited the conversation about the impact of weather-related events 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. 
 

The financial cost of wildfires

In recent years, California has battled significant wildfires that have caused severe life and property damage. Wildfires are most often caused by human error and/or electrical malfunctions, but the magnitude of such events has been greatly exacerbated by extreme weather conditions including higher temperatures, severe drought and strong wind gusts. Financial costs related to wildfires have exponentially increased in the recent years. In the last two years, U.S. wildfires have caused unprecedented damage, with losses exceeding $40 billion. 2017 losses alone totaled $18 billion, triple the previous record for U.S. wildfire damage costs of $6 billion in 1991 (CPI adjusted). The frequency and severity of weather events is further expected to rise, exposing municipal bonds to economic losses across sectors and geographic regions.
 

Increasing Number of Billion Dollar Weather Related Events

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Source: NOAA National Centers for Environmental Information (NCEI) U.S. Billion-Dollar Weather and Climate Disasters (2019).
 

Impact of wildfires 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—which 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.
 
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 levels. 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 the Federal Emergency Management Agency (FEMA), 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 wildfires 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 2017, the state committed to backfill up to three years of property taxes associated with fire losses, lessening the negative credit impact.
 

Municipal defaults

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 how much portfolio exposure there is 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 the 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 managing exposure on a state and sector level.
 
The Investment Management Group (IMG) serves as a center of excellence and the investment engine supporting TIAA Managed Accounts, including Portfolio Advisor and Private Asset Management.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax free, but other state and local taxes may apply.  If sold prior to maturity, capital gains tax could apply.
 
Diversification is a technique to help reduce risk. It is not guaranteed to protect against loss.
 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
 

This material is for informational or educational purposes only and does not constitute investment advice under ERISA. This material does not take into account any specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on the investor’s own objectives and circumstances.
 
Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.
 
The information provided herein is for informational purposes only. It does not constitute an offer or recommendation to buy or sell any security. The views expressed in this article may change in response to changing economic and market conditions. Past performance is not indicative of future returns. The examples presented in this material are for illustrative purposes only and are not intended to predict or project performance of any specific account. They do not include any withdrawals, fees, or taxes that would reduce performance. Actual returns will vary.
 
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