Weathering the Storm: Staying Ahead of Climate Risk in the Muni Market

by Lauren Kashmanian of Eaton Vance, 11/29/18

New York - As cities and states deal with increased risk of damage from extreme weather conditions, the financial impact of climate change is becoming more acute. That's why it's important for investors to understand the potential impact of global warming on the municipal bond market, both now and in the future.

Weather-related events and damage are rising

From 1980-2017, each year the U.S. experienced six weather-related events that each caused at least $1 billion in damage.¹ Yet over the last five years, the average has doubled to 12 a year. In 2017 alone, the U.S. was hit by 16 natural disasters resulting in at least $1 billion, tying the 2011 record.

More recently, so far in 2018 there have been major wildfires in California, and two major hurricanes in the Southeast, all with damages exceeding $1 billion. Along with the increased frequency of disasters, the damages from these occurrences have also been rising. Of the five most expensive hurricanes in terms of damages, three were in 2017 -- Hurricanes Harvey, Irma and Maria (the other two being Hurricane Katrina in 2005 and Hurricane Sandy in 2012).

Assessing risks for muni bonds

Despite an uptick in damage from weather-related events, we haven't seen any weather-related defaults in the municipal market. We believe, however, that it's important to incorporate the increased environmental risks into our investment decision-making process. We believe storm damage and rising seas, including coastal erosion, property damage from flooding, and other weather-related destruction, need to be assessed from a municipal credit perspective.

We attempt to incorporate key metrics related to the risks of climate change into the overall credit analysis of our municipal holdings. This analysis includes metric such as percentage of gross domestic product (GDP) generated in coastal areas, percentage of property values in a floodplain, recent flooding activity in the area, and whether the community has enacted any resiliency plans to combat risks from weather-related events.

For example, when evaluating coastal cities such as New York City -- where there is increased risk of flooding damage and the economy's entire GDP is generated in a coastal area -- we are looking at the measures the city is taking to mitigate these risks. New York City has a 10-year, $20 billion resiliency plan in place to protect the city's infrastructure from flooding and storm damage, and these resiliency measures are incorporated into our evaluation of the city's credit condition.

We believe coastal communities will continue to improve and defend existing infrastructure, especially in economically viable and important areas. Notably though, the added infrastructure costs will be costly and burdensome, so we will continue to monitor those coastal areas more susceptible to these risks and their rising costs.

Standard and Poor's (S&P) and Moody's are not currently incorporating climate change risks into their credit ratings. Ratings agencies have warned cities and states that are more susceptible to risks from climate change that they must increase resiliency measures or face credit downgrades in the future.

However, the ratings agencies have yet to downgrade a single issuer due to lack of measures taken to protect themselves from the effects of climate change. We believe that we are being more proactive and more prudent by incorporating these metrics into our internal credit rating process today.

Bottom line: As the frequency and damage of weather-related events continue to rise, we believe incorporating climate change into the credit-evaluation process for state and local issuers is important for muni investors.

¹Source for all weather event frequency and damage: National Oceanic and Atmospheric Administration (NOAA). Damage figures are inflation-adjusted, based on the Consumer Price Index (CPI).

An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Rising interest rates could reduce the value of the bonds in the portfolio, thus adversely affecting the value of the overall investment.

Weathering the Storm: Staying Ahead of Climate Risk in the Muni Market

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