Fixed Income

Municipal Credit Risk and Natural Disasters

Despite the enormity of this year’s hurricane season, we believe municipalities in the region by and large will be able to manage through these latest challenges.

09/08/2017

David Knutson

David Knutson

Head of Credit Research, Americas

Larry Bellinger

Larry Bellinger

Research Analyst, Fixed Income

With winds reaching 185 mph and having swelled to the size of France, Hurricane Irma is the most powerful Atlantic storm ever recorded.  While it is still unclear where the storm will land in the U.S.; Florida, Georgia and the Carolinas are in its path.  The Red Cross is preparing for 'a major humanitarian response' as the United Nations has estimated that 49 million people will be affected. 

Hurricane season was already well underway with Hurricane Harvey damage estimates ranging from $70 billion to $180 billion, potentially topping the previous high of $160 billion from Hurricane Katrina.  We have a number of valued clients and business partners in the affected and threatened regions and many of us have family and friends who are impacted.  Our hearts go out to them.

While we will continue to monitor the events in Houston and southeast Texas in the wake of Hurricane Harvey, we are now turning our focus on the potential credit impact of Hurricane Irma.  While an investment analysis of an industry or government facing a natural disaster is nuanced with many variables, the following are our current views.

Our municipal credit research team recommends that we hold existing exposures and even look to selectively add exposures in the affected regions depending on price action.  The financial impact of natural disasters on municipal issuers are generally mitigated by federal and state aid in addition to proceeds from insurance.  With regards to Houston and Hurricane Harvey, insured coverage is likely to be less as the overwhelming economic losses are expected to come from flooding which is specifically excluded from standard home-owners insurance policies.  Although flood insurance is also generally excluded from standard commercial policies, it is rare for companies not to buy it. 

Although major credit rating agencies said it is too soon to know whether they will downgrade issuers as a result of the storm, according to Moody’s[1], natural disasters have not caused a single default by a rated municipal borrower.  Unlike some high-yield municipal issuers such as nursing homes, charter schools or jails that may have weak liquidity and higher leverage, investment grade issuers have the financial flexibility to bridge short-term revenue disruptions with state aid and or insurance disbursements.  Although government appropriations often become politicized, given the magnitude of the uninsured flood damage of Hurricane Harvey and the potential devastation of Hurricane Irma, we expect state and federal bipartisan support for aid.

Though it is dependent on Congressional allocations, historically federal aid has covered around 70% of major storm costs.  In the case of Harvey, an aid package is already gathering broad support in Washington, D.C.  We estimate that insurance proceeds will cover approximately 20% of damages with State aid expected to cover the bulk of the remaining damages.  It is important to note that both Florida and Texas possess above average financial flexibility as evidenced by their respective AAA S&P rating.  In addition to state resources, after Hurricane Andrew in 1992, Florida created the Florida Hurricane Catastrophe Fund (FHCF).  The fund has grown because it has been able to collect premiums from private insurance companies, which rely on its backup insurance, for more than a decade without having to make a major payout because of the lack of storms.  It currently has $14.9 billion in cash, with an additional $2.7 billion in funding from “pre-event” bonds.

Total Federal Spending as a Percent of Total Economic Damage, 2000 to 2015

Source: Potential Increases in Hurricane Damage in the United States: Implications for the Federal Budget, CBO report, June 2016. a. Total federal spending as a percentage of total economic damage for hurricanes Lili through Dennis. b. Total federal spending as a percentage of total economic damage for hurricanes Katrina through Sandy.

Much like corporate sectors, where post storm revenues decline in the short term only to rebound within a year as the rebuilding phase gets underway, we expect that municipal issuers will benefit over time from improved sales and property tax revenues.  For example,  New York City passed legislation to provide property tax relief from 2014-2022 for many homeowners and business owners which saw significant increases in their property taxes after rebuilding or repairing property damaged by Hurricane Sandy in 2012. 

In the medium term, the impact from Hurricanes Harvey and Irma will be different than Hurricane Katrina, in our view.  Even though New Orleans and related government bonds did not default post Katrina, post storm economic activity was subdued due to New Orleans’ tourism-based economy and resulting population decline.  Despite the current challenges, we expect both Texas and Florida to rebound due to large, growing and diversified economies (both states are in the top ten in real GDP over last three years) as well as expected population growth which is currently running at more than twice the national average. 

While the record setting flooding caused by Hurricane Harvey and the potential for damage with Hurricane Irma has created uncertainty, we believe municipalities in both regions will be able to manage through the challenges.  We are comfortable holding our current exposure, and will look for relative value opportunities. 

[1] Moody’s US Municipal Bond Defaults and Recoveries, 1970-2016 (June 2017).

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.