Municipal Credit: Weathering the Storm
The recent Weather and Climate Report released by the National Oceanic and Atmospheric Administration (NOAA) shows that the calendar year 2021 was a historical period for weather and climate-related disasters when measured by frequency and cost. These climate related events have hit many parts of the economic spectrum, with municipal credit on the frontline as tax bases and infrastructure of state and local issuers is where these damaging events have hit the most.
The number of climate-related events in 2021 (20 events) was second compared to that of 2020 (22 events) and the cost was third only to that of 2005, roughly USD 145bn. The year 2021 also continued the trend of high-cost disasters for the seventh year in a row of 10 or more separate disasters, costing about USD 1bn or more per event. Winter storms in the southern region of the US, tornados in the Southeast states, and wildfires in the Westcoast states also gave 2021 notoriety for the diversity of calamities. The figure below displays a historical look of event frequency and cost.
Despite these challenging events, credit impairment across the entire municipal landscape remains exceptionally rare. As we continue to head into 2022, with March as the kick-off month for climate events, we expect municipals to once again be quite resilient, but when these events do come into play, we have resources to quickly evaluate any exposure, and assess the true risk. Additionally, we continue to emphasize credit selection that accounts for climate change and it remains an important factor in our environmental, social, and governance (ESG) materiality analysis.
So why haven’t such devastations also brought a corresponding rise in municipal defaults? In particular, when considering large-scale disasters brought by Hurricane Katrina (New Orleans in 2005), Superstorm Sandy (New Jersey, New York 2015), and Hurricane Harvey (Houston 2017), or by the more recent California wildfires.
The first line of defense is the timing of tax collections and the internal liquidity of municipal issuers opposed to typical semi- annual debt service. For example, property taxes are set-aside well in advance of actual principal and interest payments or sales taxes are collected monthly and often at the state level before being distributed – uninterrupted – to a local municipality. This important liquidity bridges gaps until the all-important federal and state assistance arrives. This is how the City of Paradise in California stayed current on its obligations to bondholders until rebuilding could occur, despite essentially being burnt to the ground; over 90% of its structures lost and some 80% of its population temporarily dislocated.
Federal aid, specifically through the Federal Emergency Management Agency (or FEMA) – has kept local municipalities from being overwhelmed by post-disaster costs. This includes clean-up, labor, and rebuilding. After a disaster has occurred, FEMA looks to the US Congress for supplemental appropriations for its Disaster Relief Fund and then reimburses anywhere from 75-90% of expenditures. With reconstruction underway and more money from private insurance starting to flow-in, municipal taxing schemes capture the economic activity and in turn, there is a revenue rebound and recovery. No fundamental changes in federal aid are expected this year, despite past rumblings by US Congress and proposals to change federal recovery programs. Political support should remain strong – at one time or another, every state has had a federal disaster declaration that has been supported by FEMA. The supplemental appropriations show the political willingness, but also the rising cost:
A change in US Congressional support for FEMA, or other federal disaster programs, would no doubt elevate the risk for municipal credit. Without these programs, liquidity would be threatened, and debt would likely increase to pay rebuilding costs. Further, the rebuilding of tax bases would almost certainly be delayed.
The rise in the number and intensity of events means we must continue to evaluate a municipal issuer for its exposure to climate and/or physical risks and weigh its materiality against the compensation for those risks. It is a specific factor in our ESG materiality matrix that is imbedded in our research process and was applied to over 3600 issuers in 2021. We have found the risk largely muted to-date by other factors including those discussed above. Arguably this conclusion is supported by no disruption in bondholder repayment. Additionally, we continue to wield our internal resources to pinpoint and monitor securities presumably at-risk when a catastrophic event occurs.
The month of March gets the dubious distinction for when these disastrous events begin to appear, such as severe storms in the Southeast and Central parts of the US. Of course, hurricane season – the most destructive and costly – follow and leave their mark particularly in August and September. As it all unfolds, and with this understanding in mind, we appropriately capture the risk.