Climate Risk and Municipal Bond Issuer Impairment
- US municipal bond investors concerned with climate change as a credit and portfolio performance risk have had little data with which to drive allocations and position surveillance.
- But new data from risQ provides insight into borrowers’ vulnerability across multiple climate-driven threats.
- Comparing the risQ Score with MMA data on municipal defaults shows how climate change imperils the municipal borrowers already most prone to credit impairment, suggesting an amplified credit downside to national and some state-specific bond portfolios.
Climate risk is rapidly coming to the fore in US financial markets, whether via greater adoption of international guidelines, the likes of Blackrock placing it at the center of guidance and strategy, inflows into funds and asset managers with ESG-centric approaches, and, more recently, rapidly emerging policy from federal stakeholders. By far the biggest gap in this broad-based momentum is in US fixed income, where the will to consider climate risk may be there, but the data needed for informed action have been lacking. This has been particularly the case for US municipal bonds, until now. Municipal Market Analytics (MMA) has industry-leading financial analysis for the municipal bond issuer universe. risQ has unique climate risk analysis covering the entire municipal bond universe. Marrying the two quantifiably shows that climate risk matters when analyzing municipal bond issuers.
Input 1: The risQ Score
Many have postulated about physical climate risk with respect to municipal bonds and their issuers. The National Bureau of Economic Research looked at hurricanes in isolation, showing that major storms cause local government revenues to fall by 6 to 7%, losses persisting for at least ten years after the event and causing a 6% decline in expenditures on important public goods and services. The report’s authors find a related drag on local bond ratings and issuance in this period, suggesting higher default risk among affected borrowers. A separate study by The Wharton School showed that the overall impact of wildfires on municipal budgets is also negative and substantial. But even these studies only focus on major events and fail to cover the impacts of, for example, persistent flooding, which causes outsized property and economic damage in the US.
This lack of a peril-unified, comprehensive climate risk data set for the municipal bond universe, itself based upon materially tangible, back-tested, and interpretable metrics, has prevented statistically robust analyses. The risQ Score is that singular 0–5 metric:
- Available via discrete, specific analysis for every issuer, large and small;
- Encompasses Property Value at Risk and GDP Impairment Risk as key outputs;
- Back-tested against historical losses for each of flooding, hurricane, and wildfire;
- Correlated to key municipal bond issuer indicators such as population change, property value change, and loss of ad valorem taxable property via FEMA buy-outs; and
- Conditioned for future climate change to enable forward-facing projections on an issuer-by-issuer basis.
The risQ Score represents the most complete, most rigorous climate risk data available for municipal bond issuers. It allows for all CUSIPs, portfolios, investing platforms to be compared and can be a key enabler for rational index and benchmark construction. Just as importantly, the risQ Score can be combined and analyzed against other unique, best-in-class analytics for municipal bonds.
Input 2: MMA Impairment
MMA maintains the most extensive and detailed catalog of US municipal bond payment defaults and problems since 2009. It includes 2,400 unique borrowers — and almost 21,000 CUSIPs — that have either missed payments or seen their ability to pay come under serious threat. These data show clear patterns of credit impairment with respect to borrower type, pledged security, location, year of issuance, and other factors. For example, because each state has a unique set of rules by which their local governments and not for profit entities can borrow money, there are state-by-state differences in the degree of speculation allowed in some financings, not to mention those financings’ preparedness for unforeseen developments.
Climate Risk vs Impairment — Yes, Climate Risk Does Matter in Munis
Overlapping geographic maps of climate change vulnerability to recent and ongoing municipal distress shows some community. In general, the ~1,000 municipal bond borrowers that are currently facing credit impairment tend to show higher risQ Scores, considering both overall scores and also specific scores for risk to flood, hurricane and wildfire events. A key point is that the risQ Score overall and by peril double for each integer increase (i.e., a risQ Score of 4 has twice the risk of a 3). With that context, the amplification of impairment risk correlated to climate risk can be seen below.
As the risQ Score climbs, so does the impairment probability. At a risQ Score of 3 and higher, issuers are overrepresented by at least 2.0 times across 876 impaired issuers. This climbs above 2.5 times, 3.0 times, and close to 6.0 times as the risQ Score escalates from 4.0, 4.5, and 4.9, respectively. For context, across risQ’s universe of issuers, 9.3% have a risQ Score of 3.0 or higher, 3.2% and 4.0 or higher, 1.6% are 4.5 or higher, and 0.5% are 4.9 or higher.
Given that the overarching impairment propensities bias towards high yield revenue bond cohorts — dirt deals, charter schools, CCRC’s and the like — these also represent the cohorts where larger statistical samples exist to test against climate risk. In these inherently financially riskier cohorts, climate risQ is correlated with impairment propensities, below.
Summary
The mantra we consistently hear is that climate events have never caused a municipal bond default, invoking the likes of New Orleans and Katrina as the case in point why there is nothing to see here. That’s a badly outdated, blunt instrument. Acute climate events will only grow in frequency and severity, making the current “FEMA health system” financially untenable over time: a statement that has direct and immediate impact on municipals.
Because, as the effects of climate change grow more severe, the first affected municipal credits will include many borrowers already struggling with impairment when environmental conditions are benign. Climate change could thus catalyze more and faster municipal defaults than the sector’s historically strong credit performance would suggest. Whether or not this increase is perceived to be temporary or permanent will be a critical driver of market function thereafter.
Here we note how, because few municipal borrowers default in any given year, lenders are ill-prepared for things to change. A secular increase in defaults because of climate change, even if such entails a universe of largely speculative borrowers at first, may lead municipal bond buyers to retrench more generally, strengthening underwriting guidelines and forcing outstanding bond prices lower, yields higher. In the longer term — and should climate change raise default experience among core and investment-grade municipal securities — these price and liquidity effects could be dramatic.
The backstops that have previously been in place that have curtailed defaults are becoming increasingly tenuous (FEMA) and more expensive (insurance) to maintain. Key health indicators for municipal bond issuers (population, property value) are already being perturbed by climate risk. Climate risk is only going in one direction with severities yet to be determined.
Now, and for the first time, it is clear that climate risk is assuredly correlated to financial impairment of municipal bond issuers.
Impairment precedes default. Do the math.
NBER Paper: https://www.nber.org/system/files/working_papers/w28050/w28050.pdf
Wharton Paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3612311
