Is the municipal bond market mispricing climate risk?

Bonds

Natural disasters wreak havoc indiscriminately on communities both large and small. The economic toll can be heavy because the value of property at risk has dramatically increased as people move to ever-expanding (and vulnerable) coastal communities and deeply forested areas.

According to the National Oceanic and Atmospheric Administration (NOAA), in 2018 and 2019 there were 28 billion-dollar weather related disasters. Associated losses were estimated at $136 billion — $91 billion for 2018, $45 billion for 2019. The recent record for losses was set in 2017, at $306.2 billion, which broke the previous record from 2005 of $214.8 billion.

As devastating as natural disasters can be, their impact to municipal bond prices has been muted. Frankly, prices of financial assets during the past years, both stocks and bonds, were largely unaffected by losses to real assets caused by natural disasters.

Is there a disconnect pricing the risks of catastrophes in the municipal market, which we consider a key component of environmental, social and governance (ESG) assessments?

Common sense calls for investing in bonds from areas not impacted by hurricanes, floods and fires, or demanding to be compensated when taking on natural disaster related risks. However, municipal bond pricing generally offers little to no concession when investing in high ESG risk areas, all else being equal. After all, natural disasters have led to some credit rating downgrades, yet they have not proven pervasive — and no municipal bond defaults have resulted directly from a catastrophe.

In the long run, municipal debt issuers mostly regain their footing but can be hard-pressed for a time to improve credit quality to pre-disaster levels.

Are we getting environmental risks wrong? If so, will there be a reckoning?

Perhaps the answer is no, we are not getting it wrong. The Federal Emergency Management Agency (FEMA) reimburses losses up to 75% to 90%, or more, with private insurance and state aid also contributing to recovery. Financial market participants have come to expect FEMA to support stressed situations and help alleviate short-term disaster risks. Presidential declarations of emergencies can bring valuable resources to communities in need. Those backstops are important to investor confidence.

FEMA, however, has less power to solve for the longer-term risks of outmigration and tax base erosion associated with climate change, but these risks have not significantly materialized.

If market participants cannot count on FEMA aid, that could become a serious credit negative.

There are questions about whether FEMA will step up in perpetuity. It can be an equality issue: why should taxpayers foot the expense to rebuild vacation homes? Taxpayers may lose patience with backstopping losses in known danger zones, especially for homeowners who rebuilt on vulnerable sites. Why pay for another calamity?

Some states, such as Florida and California, created programs to be insurers of last resort. State run insurance programs tend to be pricey. Property and casualty insurance is becoming prohibitively expensive in California in addition to other high tax burdens; some homeowners may decide to leave, and buyers likely will adjust purchase prices accordingly, negatively impacting real estate values. Some may move simply because they are tired of their lives being in danger.

President Donald J. Trump’s announcement recently that the federal government will inject $13 billion in aid to Puerto Rico could improve the prices of their bonds. Many investors rushed into Puerto Rico after the first hurricane anticipating all the funds that FEMA would inject into the economy to reimburse recovery and reconstruction expenses, but that aid was long delayed.

Increasing climate risks and the unwaning desire of so many to live on vulnerable coasts, flood plains and forests argue for a strong, continuing role for FEMA and other federal disaster aid.

Time will tell how the Western wildfires and Southern hurricanes impact municipal bond pricing. Given the strong positive supply and demand dynamics of the muni market, it might take significant corporate and residential tax base erosion to cause meaningful spread widening. Then municipal bonds may adequately reflect outstanding climate risks.

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