Effects of Natural Disasters on Municipal Bonds

When natural disasters occur and appear in the headlines, we are often asked about the impact on municipal creditworthiness. While the effect is unique for each event, the following provides some answers to frequently asked questions.
 
How do natural disasters affect investor behavior in the municipal bond market?
Some might expect that natural disasters would drive investors to sell assets in areas affected. In reality, municipal investment professionals are generally aware that bonds are unlikely to experience any lasting negative impact from a natural disaster, and are hesitant to sell assets during such events. Over the long-term, we believe the federal stimulus provided in response to natural catastrophes can actually improve the credit quality of disaster-affected areas. As an example, this was the case in New Jersey, where ongoing capital improvement projects were boosted from federal stimulus after Hurricane Sandy. While this certainly may not always be the situation, we believe that holding assets in those impacted areas may deliver upside potential for our clients.
Natural Disasters seem to be happening more and more often. How does climate change affect municipal credit quality?
NOAA (National Oceanic and Atmospheric Administration) suggests rising sea temperatures are contributing to higher activity in the hurricane belt every year, and rising air temperatures are a causal factor to more common and more severe natural disasters. While we see minimal short-term changes to the credit quality of municipal securities due to natural disasters, we continue to monitor the potential impact of climate change on the credit market.
How can municipal bonds maintain their creditworthiness in the face of a natural disaster?
Natural disasters have the ability to cause incredible amounts of damage to communities in their path. While citizens in those communities will inevitably face hardships because of these events, local municipalities and utilities are usually more easily able to absorb the financial strain thanks to the combination of local, state, non-profit and federal aid.
Where does financial aid come from?
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.
What about communities with fewer resources?
Communities with fewer resources might experience the short-term effects of a natural disaster more acutely than larger, more affluent communities. These communities are more likely to exhibit lower credit quality before a natural disaster and could have insufficient reserves to deploy in case of emergencies. However, short-term disruptions are unlikely to cause sustained credit deterioration once state and federal aid packages are received.
Do natural disasters lead to an increase in municipal bond defaults?
No. It is incredibly rare for an investment-grade municipal bond to default on its debt because of a natural disaster; in fact, Moody’s and S&P have both stated that none of their rated bonds have ever defaulted due to a natural disaster. Some municipal credits have even modestly improved in the years following disasters as state and federal aid packages have enabled them to rebuild and thrive. 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.
Is it true that Hurricanes Katrina and Maria respectively caused New Orleans and Puerto Rico municipal bonds to deteriorate from a credit and valuation standpoint?
Yes and No. Both credits were already suffering from economic and financial declines and had revenue bases that were pressured prior to each hurricane’s arrival. These two natural disasters are good examples of “worst case scenarios” which exacerbated long-standing credit problems.
When Hurricane Katrina hit New Orleans in 2005, the city was already struggling from declining populations, weak demographics and poorly run management. Katrina also caused one of the worst civil engineering disasters in history when the storm surge breached the levee surrounding the city causing a then-unprecedented $120 billion in damages.  In the immediate aftermath of the storm, ratings on the city’s bonds were downgraded to “speculative grade.” With the help of federal and state assistance, New Orleans was able to pay all of its debts, and has since repaired its credit rating.
As for Puerto Rico, the Commonwealth was already in default on much of its municipal debt when Maria hit in 2017. The hurricane exacerbated already existing issues in Puerto Rico, such as a severely strained infrastructure system, weak liquidity, an outsized debt burden and poor economic fundamentals.

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.

 

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.

 
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