While California has always battled wildfires, the financial, economic, and humanitarian costs have compounded in recent years. The impact on municipalities has been devastating, but municipal bond investors do have some protections and backstops that can help limit the damage to their portfolios. Still, the wildfires are another reminder that assessing climate-related risks and issuer exposure is increasingly important for investors in municipal bonds.
The cost of this year’s California wildfires is still growing, with the massive Kincade Fire only 15% contained as of October 29. All the other fires currently burning in the state are at least 75% contained, yet the damage will be extensive again this year, following estimated losses of $30 billion in 2018 due to wildfires, and an estimated $15 billion in 2017.¹
Impact on muni bonds can vary
A natural disaster will affect different types of municipal bonds in different ways, primarily due to the different types of cash flows that issuers rely on to make payments. For example, tax allocation bonds, which are secured by incremental property tax revenue from specific projects, typically have greater risk exposure than some other types of bonds, because property valuations are likely to decline materially following a natural disaster. This may negatively affect revenues derived from property taxes.
Sales tax bonds may also experience a decrease in revenues in the immediate aftermath, although higher spending driven by rebuilding may actually strengthen these credits over time. Municipal utilities are likely to receive state support, which typically helps shield rate payers from significant cost increases in an already trying time.
General obligation (GO) bonds issued by local governments also aren't immune to the impact of natural disaster. If a large enough portion of a town is destroyed by wildfire, the tax base and the source of most GO bond security will disappear, affecting the issuer’s ability to make bond payments; however, not all local governments affected by natural disasters will face the same level of credit deterioration. Some damage is covered by insurance, and other areas may receive assistance from state reserve funds or FEMA. Many local governments also maintain the reserves and liquidity to continue operations and start rebuilding.
Lessons from the recent California wildfires
What can muni bond investors learn from recent California wildfires? One example is from 2018, when the town of Paradise, located in Northern California, was virtually destroyed by the Camp Fire. An estimated 80% to 90% of the town was ruined, including over 6,500 residences and 260 commercial buildings. Approximately 90% of the population was forced to leave.
In order to meet the debt service on its capital appreciation bonds, Paradise benefited from legislation that allowed the state to backfill payments due to lost property tax. Additionally, the state of California secured direct federal assistance to support affected communities such as Paradise. As a result, municipal bonds issued by Paradise were able to make all debt service payments as scheduled. This example of extreme damage highlights the many options municipalities may have to maintain financial solvency as they rebuild their communities.
Like any natural disaster, wildfires bring with them terrible losses, including financial damages, lost economic activity, and—often—human life. Fortunately, affected state and local governments can increasingly rely on rainy day reserve funds and internal liquidity. Those municipalities that have responsibly grown reserves are likely to fare better in the face of disaster than those that haven't.
While no one can accurately predict the next natural disaster, for municipal bond investors it's important to assess the risk exposure to wildfires in California both at the state and issuer-specific levels. We believe robust bottom-up fundamental analysis and a complete understanding of the underlying credit risks of each bond issuance, including levels of preparedness to recover from natural disasters, are essential for sensible investing in the municipal bond market. As the number of wildfires in California continues to rise, with increasing amounts of devastation left behind, this analysis becomes even more paramount in areas with higher potential for natural disasters.
1 California Department of Forestry & Fire Protection, as of October 2019.