Munis on a rainy day

E*TRADE Securities2

10/12/17

The roads we drive. The schools we attend. The hospitals we go to when we’re sick. They’re part of our daily routine, often made possible by municipal bonds. But what happens when Mother Nature wreaks havoc on such infrastructure? Should investors grow concerned if disasters strike areas supported by their portfolio? Damage estimates from the spate of hurricanes across the U.S. Gulf Coast and Puerto Rico are in the hundreds of billions, leaving many to wonder how the affected municipalities will cope.

Priority number one is to secure the safety of those affected. But also on the list is determining how well these public entities are positioned to rebuild and provide essential services, and to remain solvent while doing so. For investors, such factors are important when assessing a portfolio’s exposure, as evidenced by the situations in Texas and Puerto Rico. 

Muni bond considerations after the storms

Well-positioned

Being financially fit before a storm increases the likelihood of a municipality being able to weather its effects. So as it cleans up after Hurricane Harvey, it works in Texas’ favor that its public finances are strong. Texas is one of the fastest growing economies in the US, a by-product of its energy boom. Of course, significant financial aid from the Federal Emergency Management Agency (FEMA) will help the process too.

Speaking of FEMA, it declared 18 Texas counties disaster areas, all of which have investment-grade credit ratings from Moody's Investors Services and/or Standard & Poor's, including Houston. That is significant should those counties need to issue debt to fund repairs to damaged infrastructure. 

Moody’s did flag bonds from a number of issuers in Texas for possible downgrades. However, many are considered smaller municipalities with concentrated revenue sources, while others had credit difficulties prior to the recent natural disasters.

A different story

Holding municipal bonds from already distressed areas when natural disasters strike could make a risky situation worse for investors. Under water from a pile of debt that forced it to declare bankruptcy in May, Hurricanes Irma and Maria socked Puerto Rico’s electrical grid, roads, telecommunications, water, and hospitals. The island’s government has little, if any, financial flexibility to tend to such essential infrastructure. And that reality has sent bond prices plunging.

The benchmark general obligation bonds maturing in July 2035 traded at an all-time low of 30 cents on the dollar recently, down from 56 cents last month. Market observers attribute some of that dip to President Trump suggesting that he would forgive the $74 billion of the municipal debt Puerto Rico owes, and investors interpreting that comment to mean that bond prices were actually too high.1 While nice for the island’s government to think about, most will tell you wiping out its debt is not feasible.

Disaster aid is viable though, and the White House sent Congress a request for an initial $29 billion in assistance. However, officials know it will take much more to re-establish even basic services. And somewhere down the line mediators will figure out how Puerto Rico can follow the 10-year debt restructuring plan Congress laid out following its bankruptcy filing. 

To consider

For bondholders, an issuer’s underlying finances and positioning are typically more important when assessing their creditworthiness than the effects of any one-off event. In fact in some instances, a storm’s aftereffects can lead to improved creditworthiness and tax revenue given the financial commitment made to rebuilding, and perhaps improving, infrastructure.

In light of recent events, investors looking into muni exposure may also want to consider the following:  

  • Climate events increasing in frequency could make geographical diversification an important component in muni bond selection, especially if one area is more prone to hurricane-like events than another. Notable, too, is that residents of states without state income taxes, Florida and Texas included, can hold out-of-state muni bonds in their portfolio without increasing their tax bills.
  • Bond structures similar to the Liberty Bonds created after 9/11, which are designed to aid recovery from catastrophic events, may be something to look into, should they be created, to help Texas, Florida, Louisiana, and Puerto Rico recover.
For investors that may be concerned about Mother Nature’s wrath on municipal bonds, know that Moody’s calmed some nerves recently, stating that none of the bonds it has rated has ever defaulted because of a natural disaster.2 Munis remain one of the most strategic ways cities, states, and public entities can develop—or rebuild—their infrastructure. And they remain one of the more popular investments to help generate income—tax-free, in many cases.      

 

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1. Gillers, Heather. “Puerto Rico Bonds Slide as Trump Says ‘Goodbye’ to Territory’s Debt,” The Wall Street Journal, 4 Oct. 2017. https://www.wsj.com/articles/puerto-rico-bonds-slide-as-trump-says-goodbye-to-territorys-debt-1507126128?mg=prod/accounts-wsj

2. Spalding, Rebecca and Moran, Danielle. “Why Harvey’s Not Rattling a Bond-Market Haven: Quick Take Q&A,” Bloomberg, 30 Aug. 2017. https://www.bloomberg.com/news/articles/2017-08-30/why-harvey-s-not-rattling-a-bond-market-haven-quicktake-q-a