Munis in Focus: Adjusting the Sails

"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” This quote from American writer William Arthur Ward seems apt when considering the municipal investment landscape in the final quarter of 2017 – a time when strong winds, both literal (in the form of a punishing hurricane season) and metaphorical (in the form of policy headwinds and tailwinds), are buffeting the muni markets. And it has never been more important to respond with a pragmatic, active approach.

In this edition of Munis in Focus, we discuss how we’re “adjusting the sails” of our portfolio positioning to help investors address both the short-term and longer-horizon challenges of extreme weather events and policy shifts, while taking advantage of opportunities they may create.

Lessons from a brutal hurricane season

Hurricanes Harvey, Irma and Maria have taken a devastating toll this year on the communities and citizens affected. While their impact on municipal credit is likely to be somewhat muted – neither S&P nor Moody’s has ever recorded a bond default resulting directly from a natural disaster – credit deterioration is possible. In fact, the rating agencies have assigned negative credit outlooks to a number of smaller borrowers (primarily utility districts) in the regions affected by the hurricanes.

When assessing the risk to a bond posed by potential natural disasters, it’s important for investors to consider several key factors:

  • The bond’s security features. We view asset-dependent bonds to be most at risk, and bonds secured by revenues from a single asset are of particular concern. Examples include certain types of lease revenue bonds and bonds secured by student housing facilities, assisted-living and senior facilities and single-site hospitals. While various forms of property insurance would generally be included in the security packages for these bonds, they may not be sufficient to prevent credit impairment.
  • Expected federal disaster relief. The federal government will provide assistance in rebuilding efforts, with FEMA covering up to 75% of storm-related repairs and debris removal. Legislation is already moving through Congress to provide additional relief.
  • Initial conditions of the local economy and the financial health of the credit itself. This is perhaps the most important consideration, as the following examples illustrate (we discuss Puerto Rico in greater depth below):

Hurricane Katrina and the City of New Orleans. In the year following Hurricane Katrina, the City of New Orleans saw its population drop by more than half, sales tax revenues fell by 20% and the regional economy contracted over 7% in real terms. While the city avoided default, it experienced significant credit deterioration, and its population remains below pre-Katrina levels, with regional GDP still 12.3% below 2004 levels as of year-end 2016.

Superstorm Sandy and the New York MTA. Increased credit risk can manifest itself in increased leverage, as we saw with the New York Metropolitan Transportation Authority (MTA) following Superstorm Sandy. In response to the storm, the MTA revised its capital plan up by roughly $5.674 billion. The MTA relied on a combination of short-term borrowing to bridge the gap before receiving federal reimbursement. Favorably, the local economy and the MTA’s resources and capabilities were strong enough to withstand the impact.

Hurricane Harvey and the City of Houston. Despite some recent weakness related to the energy sector, the Houston economy appears well positioned to weather Harvey’s impact. The city’s population has grown at a 1.6% compound annual growth rate since 2010. Prior to the storm, unemployment was a modest 4.7%, and total employment was up 1.2% year-over-year as of July. Houston’s controller has also stated that it will not sell new or unplanned bonds to pay for Harvey-related expenses.

All told, we expect Hurricanes Irma and Harvey to inflict transient modest fiscal stress on municipal credits in the areas affected, while the rebuilding efforts will likely provide a temporary surge in economic activity.