January 8, 2020
There is increasing apprehension about the potential impacts of climate change on municipal bond markets. As highlighted in a recent Barron’s article, BlackRock cautions that within ten years, 15% of the S&P National Municipal Bonds Index will come from cities and towns estimated to incur annual climate-related losses of .5% to 1% of GDP. Given that municipal bond repayment often comes from local property tax revenues, some investors and rating agencies are growing concerned about whether these investments could be at risk if property values decline due to disaster events and/or unmitigated sea-level rise. The Risk Center reached out to Robert Fernandez, Andrew Teras, and Michael Bonanno at Breckinridge Capital Advisors (a fixed income investment firm) to learn more about climate-related municipal bond risks. Here are their responses to a number of our questions.
How recently have investment firms and rating agencies been thinking about climate-change risks within the municipal bond market?
“Municipal market participants have devoted increasing attention to climate-change risks over the past two to three years. As the frequency and severity of hurricanes, flooding, and wildfires has intensified, investors are growing more concerned about the extent to which an issuer’s vulnerability to natural disasters may be material to credit risk. Investors are also attuned to more gradual effects of climate change (such as water scarcity and heat stress), but there is less consensus regarding how these longer-term risks might hamper a municipal issuer’s ability to repay its debt.
Rating agencies have taken notice as well. Moody’s Investors Service, S&P Global Ratings and Fitch Ratings have all published pieces explaining how climate risks are integrated into their municipal credit ratings. We believe this a positive development for capital formation in the municipal bond market and may encourage states, cities and other borrowers to be more proactive in planning for these risks.”
We understand you have been doing some work in Florida that involves speaking to municipalities about climate change risk and municipal finance. Could you tell us a bit about this work?
“Breckinridge engages with municipal borrowers across market sectors to learn about environmental, social and governance (ESG) trends that may be applicable for them. We also encourage issuers to improve transparency on ESG risks and provide them our perspective on how investors are considering these risks.
Over the past few years, Breckinridge research analysts have had discussions with representatives of several local communities in Florida that are vulnerable to hurricanes, coastal flooding and sea level rise. We also recently spoke with Ben Watkins, Director of the State of Florida’s Division of Bond Finance, about the importance of climate-related disclosure and coordinated intergovernmental efforts.
The Florida municipalities we spoke with are working to align capital spending programs with resiliency initiatives to address climate change-related risks. They emphasized the importance of regional collaboration as a catalyst for developing strategies to address climate challenges. A few of these communities are members of the Southeast Florida Regional Climate Change Compact, an entity that has been instrumental in spearheading a regional response to sea level rise.”
Should the average investor be concerned about climate change risk and municipal bond markets? Broadly, who should be concerned about these issues?
“All stakeholders, including investors, taxpayers and government officials, should be cognizant of climate change risk and how it may affect the ability of municipalities to provide basic services to their residents.
Communities in some regions of the country are already grappling with significant climate-related challenges. For example, in certain parts of the western U.S., land subsidence – a gradual settling or sudden sinking of the Earth’s surface – caused by overdraft of local groundwater basins during prolonged droughts has damaged public infrastructure such as roads and aqueducts. This infrastructure must be rebuilt, requiring substantial allocations of taxpayer dollars that could be otherwise invested in climate adaptation projects or essential public services such as schools or health care. We believe that local governments in arid regions that fail to take proactive steps today to address water scarcity concerns will be fighting an uphill battle as instances of severe drought become increasingly common over the next few decades.
Stakeholders also should be aware of the potential for shifts in federal and state support in the aftermath of natural disasters. Historically, severe weather events have infrequently degraded the credit quality of municipal issuers, in part due to receipt of federal and state disaster recovery aid. However, dwindling discretionary resources, political gridlock and the increasing frequency of severe weather events could cause this support to become less generous in the coming years. This means that municipal issuers are likely more vulnerable to natural disaster risk than previous history might suggest. In certain circumstances, considering an issuer’s preparedness for a natural disaster, both financially and in terms of long-term planning, should be an element of prudent credit analysis.”
If we believe that market prices adjust to reflect available information on risks, we would assume that bonds with long-enough maturities would trade at prices that encompass climate-related risk. To investigate whether or not this is happening, a few academic papers have looked at whether or not municipal bond prices accurately reflect risk exposure to sea level rise. Some find no price effects while a recent paper by Goldsmith-Pinkham et. al finds a very small, but measurable price effect on credit spreads in sea level rise-exposed areas. Do you think that muni bond prices already reflect these risks? If not, in what timeframe do you anticipate municipal bond markets will start to reflect climate-related risks?
“We do not believe there is enough evidence to conclude that municipal bond prices reflect climate risk on a widespread basis. This is true for several reasons.
First, most municipal bonds are infrequently traded. This makes it challenging to isolate a singular variable as the primary driver of bond valuations, and pricing movements can occur even absent a change to the credit risk fundamentals of the municipal borrower.
Second, historically low interest rates and strong investor appetite for municipal bonds has resulted in very attractive borrowing costs for municipal issuers. As a related matter, investors are not demanding a significant premium when purchasing bonds from borrowers with weak credit profiles versus those perceived to have very low credit risk.
Finally, investors have observed few instances where climate risk has been a major driver of credit distress for a municipal borrower. As a result, market participants may be sanguine about the potential for climate risk to cause a bond impairment.
It is difficult to predict when bond pricing will begin to reflect climate change risks. Should a large municipal bond issuer experience a prolonged payment default attributable to a severe weather event, or, perhaps, a precipitous decline in tax revenue following a collapse in coastal property values, market participants may begin to meaningfully rethink norms regarding climate change risk. Bond pricing impacts could be magnified if these events were to occur during a period of dislocation in the financial markets.”
We can imagine that high-risk regions that do not undertake mitigation efforts might gradually be given lower credit ratings on the bonds that they issue. Lower credit ratings coupled with higher magnitude future storms competing for limited federal assistance could make recovery more difficult and expensive. Is this something to be concerned about? In which areas might we be most concerned about this?
“We are most concerned about smaller communities with relatively shallow tax bases. Given our belief that there will be a dwindling pot of money for disaster recovery, we wonder if these places will be overlooked in favor of larger cities that operate highly essential infrastructure and serve as major economic hubs.
We also believe communities that already carry low credit ratings due to a baseline level of fiscal stress will be challenged as the effects of climate change intensify. These municipalities may lack the financial resources to absorb a greater share of recovery costs and may have trouble accessing the bond market to fund infrastructure repairs and climate adaptation projects that would protect against future storms.”
Moody’s Corporation recently purchased a share in Four Twenty Seven, a market intelligence firm specializing in measuring the economic risk of climate change. Do you think this is significant?
“Moody’s purchase of Four Twenty Seven signals that the agency is becoming more serious about integrating quantitative measures of climate risk into its research process. This should improve transparency and provide investors with better information to assess how climate risk factors may influence credit ratings. Furthermore, we believe municipal issuers will need to be more forthcoming regarding climate disclosure and may face more detailed climate-related questions when issuing bonds.
That said, we don’t think that Moody’s application of new quantitative climate risk data will result in widespread changes to credit ratings in the near term. If there are changes, we suspect that lower rated issuers would incur a disproportionate number of rating downgrades.”
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The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of December 20, 2019 and are subject to change without notice.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal.