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Fixed-Income Insights

Here, we offer four takeaways for municipal bond investors from the recent run of U.S. storms.

[Note: This article is from the October 2017 edition of The Muni Quarterly.]

The tragedy experienced by victims of hurricanes Harvey, Irma, and Maria is one of lives uprooted, communities lost, and peace of mind shattered. As municipal bond investors, we feel deep sympathy for people affected by these storms, while also remaining professionally concerned about the ongoing credit quality of the securities held in Lord Abbett’s muni bond portfolios.  In this article, we make a few key credit observations based on our experience with several recent natural disasters in order to generate accurate expectations for future performance. Ultimately, we observed that municipal issuers within disaster-affected areas typically maintain their credit quality despite short-term disruption.

1. The U.S. system of emergency support and preparedness is strong, but moves slowly.
Federal and state support provides a strong backstop for municipal credits affected by natural disasters. With its established programs, largely administered by the Federal Emergency Management Agency (FEMA), the federal government assumes a large (and growing) portion of recovery costs for municipalities. This is a key reason why natural disasters do not inflict more serious and widespread damage to the credit profiles of affected entities. In addition, a sizable portion of costs not picked up by the federal government is borne by the states (see chart). 

 

The U.S. Government Has Absorbed a Greater Share of Costs from Recent Storms
Total federal spending as a share of total economic damage for selected hurricanes, 2000–15

Source: Standard & Poor’s, based on Congressional Budget Office data. Copyright © 2017 Standard & Poor’s Financial Services LLC. All rights reserved.

 

There are, however, two notable challenges to this system. First, most governmental aid is distributed as a reimbursement for costs already incurred, meaning that entities need to have sufficient cash flow and liquidity to pay for immediate recovery efforts, cover debt service, and provide needed services to citizens. Reimbursement can come slowly, putting pressure on more cash-strapped municipalities. Second, while disaster-relief programs capably support close to 100% of municipalities’ damages, individuals and businesses (particularly those without insurance) will not see nearly as high of a recovery rate. Individuals can apply for disaster assistance funds from FEMA that typically total around $3,000–4,000, and also can receive low-interest loans from the Small Business Administration. Because these funds typically will not cover the full cost of an individual’s damages, natural disasters can have a huge impact on the citizens of an affected municipality, influencing economic activity in a way that may impair revenue growth.

2. Sales tax revenue in U.S. municipalities responds predictably after a natural disaster.
Municipalities hit by natural disasters will often see spending drop off in the immediate term, while businesses are closed and individuals are assessing damages. This leads to a short-term drop in sales tax revenue, particularly if an affected municipality temporarily suspends sales taxes. However, after this initial lull, sales tax revenue typically increases sharply, as individuals, businesses, and government entities purchase materials needed to fund recovery efforts. For example, after Hurricane Katrina, sales tax revenue in New Orleans fell by 24% during 2004–05. However, over the following three years, sales taxes grew by 7%, 8%, and 3%, even with a population that was 47%, 54%, and 61% of the prior highs due to storm-related displacement. This represents a 35% increase in sales taxes per capita due to recovery-related spending.

3. Population declines are a longer-term challenge, particularly for revenue-supported sectors.
While temporary relocation of citizens in hurricane-affected areas is expected, a longer-term decline in population can pressure operating revenue, particularly for entities such as higher education and healthcare institutions, which are dependent on providing services in exchange for fees. At universities and hospitals, a decline in their enrollment/patient base can create significant shortfalls that pressure credit quality. An extreme example of this is what happened to New Orleans’s universities after Hurricane Katrina. Due to damage from the hurricane, these institutions remained closed for the duration of the fall semester, leading to enrollment declines of up to 50% and requiring significant expense cuts. Even now, most institutions have enrollment bases that remain below pre-Katrina levels, reflecting regionally focused student markets with population numbers that have not yet fully recovered. The impact of later hurricanes, such as Hurricane Sandy and Hurricane Harvey, was more muted, because regional colleges and universities were able to reopen during the fall semester, preserving vital tuition dollars even as they worked through clean-up efforts.

More broadly, long-term population declines can also affect state and local government revenues through reduced tax collections. We expect that larger and more-diversified economies will suffer less-severe long-term population declines than smaller regions with less-entrenched businesses and industries. For example, the population of New York City was up 3% in 2016, four years after Hurricane Sandy, and did not decline a single year after the hurricane. In contrast, New Orleans’s population remained 34% lower than pre-Katrina levels even four years after the storm. While part of this difference is likely due to the differing severity of the storms, we believe the essentiality and uniqueness of the New York City economy also played a role.

4. Since Katrina, the responses of credit rating agencies to natural disasters have been fairly subdued, partially thanks to stronger initial credit quality in more recently hit areas.
Of the approximately 92 Moody’s-rated credits affected by Hurricane Katrina, 51 were placed under review and 29 were ultimately downgraded (the other 12 retained their ratings). This 55% review rate is by far Moody’s highest when compared with other credits affected by hurricanes that took place over the last 15 years. The agency reviewed only 2% of credits affected by Hurricane Ike, 1% of credits affected by Hurricane Irene, 1% of credits affected by Hurricane Sandy, and 0% of U.S. credits affected by Hurricane Irma. In response to Hurricane Harvey, which affected 450 credits along the U.S. Gulf Coast, Moody’s placed 36 credits under review (8%).

Overall, we have observed a few key factors that contributed to the lack of substantial disaster-related rating activity in recent years: 1) the concentrated and substantial damage imposed by Hurricane Katrina has not been duplicated (as far as municipal credits are concerned); 2) since Katrina, federal, state, and local government preparedness and response mechanisms improved materially; and 3) when compared to New Orleans in 2005, the municipalities affected by more recent hurricanes generally had stronger credit profiles when the storms hit, giving them more flexibility to adjust while maintaining their ratings.

A Resilient Market
To conclude, we expect the muni market will remain resilient in the face of natural disasters, with entities largely maintaining prior levels of credit quality. Obligors facing higher levels of risk are usually subject to additional and unique negative circumstances, such as weak liquidity and revenue bases that were pressured prior to a disaster’s arrival. For instance, the damage caused by Hurricane Maria will be more consequential for Puerto Rico than many of the recent hurricanes discussed in this piece. This is due to the island’s already-challenging financial position and a strained infrastructure system that was already facing significant deferred maintenance before the storm. We will continue to evaluate our holdings on a case-by-case basis and take appropriate action as needed.

 

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THE MUNI QUARTERLY

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The October 2017 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.

July 2017 edition
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