At our Monthly Muni Strategy Meeting last week, the investment team analyzed the potential risk of hurricanes on Muni bond sectors and Muni credits. One might ask, why talk about hurricanes during a week when winter storms dropped snow in the South and caused blizzard conditions in parts of the Northeast? We believe it is important to understand the potential impact of natural disasters on municipal credits, and as hurricane season begins in about 70 days, it is worth understanding the risks to portfolios well before a storm is at your doorstep.
While wind and storm surges from hurricanes have the potential to cause billions of dollars of damage, most municipal credits have been able to maintain strong credit quality even after a storm has passed. One reason that the financial impact from a storm may be mitigated is that municipal governments benefit from the assistance property and casualty insurers provide for property owners who make up the tax base, and from federal emergency agencies who provide support to both property owners and to municipal governments. There are a number of other characteristics municipal governments may have that help enable them to maintain strong credit quality even after a storm has passed:
- Tax/Revenue Base Size, Diversification and Population Stability: Large, diverse tax bases, such as a state or a large county or city, should feel a relatively smaller financial impact from storm damage than a smaller more concentrated tax base, such as a land-backed tax increment or a special assessment district, which could be wiped out by a storm. A stable population base with adequate resources is also more likely to rebuild the tax base after the storm than a population with fewer resources.
- Security Pledge, Coverage Levels and Bondholder Protections: The type of security backing a muni bond, the level of tax or revenues, and bondholder protections like strong additional bonds tests and debt service reserves can provide adequate cushion to maintain strong credit quality. For example, a local government’s unlimited tax general obligation pledge will provide more security and a greater ability to raise revenues than appropriation backed debt, which typically does not have a dedicated source of revenue. Bonds backed by sales tax revenues, for example, could benefit from revenues generated from the purchase of goods used for rebuilding, while taxes from hotels could be delayed if hotel facilities remain closed or tourists are discouraged from visiting the storm area.
- Management/Policy: Good management procedures and policies may be reflected not only by emergency preparedness, but also by a track record of maintaining and improving infrastructure, and building financial reserves that could provide a cushion during a period of rebuilding.
While many municipalities have been able to weather the storm, not all credits are created equal, and a combination of storm location and intensity and a lack of financial cushion have provided evidence of weaker credits’ vulnerability to natural disasters, including hurricanes. The combination of an intense storm and weak credit characteristics can lead to prolonged recovery and rebuilding, which in turn can cause downgrades or defaults. Comparing New York City and New Orleans provides an example of differing credit impacts from hurricanes. Both cities suffered severe damage, New York from Hurricane Sandy in 2012, and New Orleans from Hurricane Katrina in 2005, but the credit impact was far less severe for NYC. Both storms were intense, though Sandy only reached Level 3 while Katrina hit Level 5, but there were other factors that helped New York maintain its ratings. New York appeared to be better prepared, and its larger, more diverse and much stronger underlying economy, as well as its stable population, contributed to maintaining its tax base. New Orleans was already a relatively weak, BBB rated credit before Katrina hit, and it was downgraded to non-investment grade after the storm. Nearly twelve years later, a period that includes one of the longest periods of national economic growth, the population of the city is still below its pre-Katrina level. As it continues its slow recovery, New Orleans has been upgraded to low A rating category levels.
Beyond understanding the hurricane risks to each Muni sector and to individual Muni credits, we also want to ensure that our portfolios are adequately diversified. We believe that managing hurricane risk goes beyond sector and security diversification. We also want to make sure that credits are not concentrated in any one region in hurricane risk areas. A portfolio that holds a local GO, a dedicated tax bond, an airport, a higher ed, a hospital, a public power system, a toll road, and a water system would appear to be diversified, but if each of those names were located in one region, like in New York City, New Orleans, or another hurricane prone metro area, then the credits would be correlated and not properly diversified from hurricane risk. We will continue to review muni-based portfolios to ensure that they have proper sector, credit and regional diversification to mitigate hurricane risk.
Source: Fitch Ratings and Moody’s Ratings