Climate risk still relevant
for muni bonds

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March 3, 2021
 

Over the past year, the occurrence of climate-induced natural disasters accelerated in the US. 1 Although COVID-19 became the top priority of state and local governments, some of them already had climate mitigation projects planned. As the economy recovers, the credit quality of some municipal bond issuers will depend on their level of climate vulnerability and what they do to ease future impact, according to Jeffrey Sayman, Senior Municipal Bond Analyst at Mellon.

In 2020, it was evident climate change was still impacting state and local government fiscal health. There were a record 22 natural disasters in the US with losses in excess of US$1bn each, surpassing the previous record of 16 events in 2011 and 2017.1

To illustrate the severity, 2020 was the sixth consecutive year in which over 10 billion-dollar weather events struck various regions of the US. During this six-year period, there were 16 annual events on average compared with an average of seven annual events from 1980 to 2020.

What actions are states taking?

As the incidence rate of these events increases, municipal issuers are forced to address the growing climate challenge with increased spending, revenue generation and debt issuance, which can meaningfully impact their overall financial profile.

According to Mellon, it’s important to identify distinguishing characteristics of better-situated and morevulnerable issuers. For those more vulnerable issuers, it’s important they recognize the climate challenges ahead and begin to take mitigation steps. “There’s been recent progress with Florida announcing a major climate initiative in January,” Sayman says.

Florida Governor Ron DeSantis announced a US$1bn investment in infrastructure projects, over the next four years, to address the impacts of climate change. If approved by its legislature, the new program called “Resilient Florida” would pay for the debt service on US$1bn in bonds issued to build sea walls on government structures in order to combat rising sea levels, in addition to other projects to address impacts of climate change.2 “The US$1bn pledge reflects positive efforts and addresses the continuing problem of over $140 billion in taxable property at risk of being flooded in less than 30 years,” Sayman says.

Similarly, the state of Louisiana outlined an initiative aimed at reducing the impact from hurricanes with $877 million of spending in fiscal year 2022. As part of a longer-term initiative to save shorelines from endangerment, the project plans to build more than 23 square miles of wetland by directing Mississippi River sediment into nearby marshes.3

Research suggests that environmental approaches to addressing flood risks offers a more effective alternative for shoreline stabilization. “In Louisiana’s instance of restoring marshland, projects focused on soft-barriers to act as a natural barrier against rising seas and storm surge has been historically more cost-effective than traditional hard barriers, such as seawalls or elevating properties,” Sayman says.

Recent studies suggest the “living shoreline” method is not just a “green” defensive approach, but also lowers flooding costs and damage rates.4

Independently, other governments have taken an alternative approach to mitigating climate risk through regulation. Following a 1997 flash flood, after more than $200 million in damages were incurred and five lives were lost, city officials in Fort Collins, Colorado passed regulation restricting construction in the Cache la Poudre River’s flood plain. It included a ban on residential construction in 100-year flood plains, and non-residential developments were permitted only if they were at least two feet above the projected flood levels. The regulation was ultimately substantiated when the Fort Collins area underwent flooding in 2013 without major structural damage or casualties.5

Will increased climate costs lead to further economic disruption?

Significant climate change events can have devastating effects on state and local governments, adding fiscal pressure at a time when tax revenues have declined due to the COVID-19 pandemic. “States are facing budgetary challenges from the pandemic with estimated state revenue losses of US$200-300bn6 from 2020-2022,” Sayman says.

Rainy-day funds, as well as federal aid, have somewhat offset the maximum severity of budget impact. State year-end balances have hovered between 10% and 12% of general fund spending and rainy-day funds, which have bounced between 5% and 7%, have provided some flexibility. “States have already received a total US$150bn in federal aid from the CARES Act as well as a proposed US$350bn in combined state and local government aid from the next stimulus package,” Sayman says.

Despite this, current short-term budget impairments, occurring simultaneously with extreme climate events, could signal future increased climate costs for state and local governments. For perspective, it is estimated that average annual losses from hurricane activity are on pace to reach $108 billion by 2100.7

According to Sayman, some of the ways that states can address future climate risk includes elements of all three of the aforementioned approaches: hard structures, soft barriers, and amplified regulation. “Means to address climate risk on the state level depend on several variables, including geographic location, so it’s not a one-size-fits-all discussion,” Sayman says.

“Whether it’s an energy company or a municipal bond issuer, we believe it’s important for investors to consider which issuers are most vulnerable to extreme weather and natural disasters,” David Leduc, chief investment officer of active fixed income at Mellon, says. “If it’s in an area subject to wildfire risks, or a coastal area where it’s vulnerable to storms and rising sea levels, it’s going to have some effect on the credit quality.”

Ultimately, credit risk does not solely depend on an issuer’s geographic susceptibility to extreme weather. “Not all coastal credits in flood-prone areas can be generalized to have a similar level of risk,” according to the municipal bond team at Mellon. “Adequate reserves and liquidity levels are key for covering any rebuilding costs without receiving government assistance and support from markets. A complete review of numerous factors, including an intensive fundamental credit review, is still necessary,” they conclude.

1 National Oceanic and Atmospheric Administration: Record number of billion-dollar disasters struck the US in 2020. January 8, 2021.

2 Tampa Bay Times: DeSantis calls for $1 billion to brace for climate change. January 8, 2021.

3 The New Orleans Advocate: A look at Louisiana coastal spending plans: Build 23 square miles of land, add levees,more. February 18, 2021.

4 Scientific American: Rebuilt Wetlands Can Protect Shorelines Better Than Walls. April 1, 2019

5 Governing.com: Increasing Numbers of U.S. Residents in High-Risk Wildfire and Flood Zones. February 4, 2021.

6 The Brookings Institute: Why is State and Local Employment Falling Faster Than Revenues? December 23, 2020

7 Risky Business: The Economic Risks of Climate Change in the United States. June, 2014.

 

Risks:

All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines.

The amount of public information available about municipal securities is generally less than that for corporate equities or bonds. Legislative changes, state and local economic and business developments, may adversely affect the yield and/or value of municipal securities. Other factors include the general conditions of the municipal securities market, the size of the particular offering, maturity of the obligation, and the rating of the issue. Income for national municipal funds may be subject to state and local taxes. Income may be subject to state and local taxes for out of state residents. Some income may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable.

Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.

Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or financial professional in order to determine whether an investment product or service is appropriate for a particular situation.

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