How to Mitigate Natural Disaster Risk in Your Muni Portfolio

Our thoughts and prayers go out to every individual and family impacted by the devastating fires in the Los Angeles area. Losing a house – let alone life – is unimaginable and the rehabilitation process beyond stressful for thousands of people.

 

Takeaways:

• We expect municipal credit health to remain resilient in the Los Angeles area.
• A yearslong period of uncertainly will ensue, but over time – due to a variety of fiscal levers and rebuilding efforts – the area will recover.
• A Senate Budget Committee report correlates highly with FEMA’s National Natural Disaster Risk Index, with both playing a role in our internal credit analysis.
• We believe a concentration to Midwest and Texas issuers helps i.) mitigate natural disaster risk while also ii.) maximizing after-tax yield compared to the benchmark.

 

The wildfires have spotlighted natural disaster risk present in municipal bond portfolios. However, over the past two decades from Katrina to Harvey, New York to California, municipal credit has remained durable and, in many cases – due to rebuilding efforts – emerged stronger than before.

S&P rated New Orleans BBB+ prior to Hurricane Katrina in 2005. 10-years later the city was upgraded to A- and now rests at an A+ rating.[1] Obviously there was a period of deep uncertainty immediately following the storm, but non-payment never occurred. The credit remained resilient following an extremely acute event where the city experienced upwards of a 30% decline of its population.

Los Angeles and its various municipal obligors – most prominently Los Angeles Department of Water & Power – are now in a time of uncertainty as the fire responsibility and resulting liabilities are being investigated. Our firm has overall low exposure to CA-based credits, and no exposure to the Department of Water & Power bonds, specifically. That said, we have confidence that a combination of state and federal assistance will mend the fiscal gap, while local revenues remain resilient given they are diversified and the area is still a desirable place to live and rebuild over time.

A plot of land in the Palisades neighborhood with remnants of a scorched home destroyed by the fire recently went up for sale for $1mm and received over 60 offers. The house was last valued at $2.7 million.[2]

Insurance will further dampen the financial impact of the disaster as individuals are able to partially recoup their loss and, hopefully, successfully rebuild their home and lives in the area. This said on a national scale, increasing insurance non-renewal rates could portend future credit weakness for certain areas of the country. A recent Senate Budget Committee report[3] flagged geographies experiencing an increase in insurance companies not renewing policies. The report was made possible from information from 23 insurance companies that compose 65% of the property insurance market from the years 2018-2023. In their request for information, the Senate committee noted a weakening insurance market and/or ballooning premiums in states like California, Louisiana, and Florida.

The states with the highest 2023 non-renewal rates are as follows:

State	Non-Renewal % 2018	Non-Renewal % 2023	Change 2018-2023
FL	0.79	2.99	2.2
LA	0.49	1.80	1.31
NC	2.07	1.79	(0.28)
CA	0.94	1.72	0.77
MA	1.18	1.51	0.34

The report notes there is a clear correlation between non-renewal rates and natural disaster risk. Among the report’s other findings:

• All 10 of the top 10 states ranked by insurance non-renewal rate were either coastal states…; [or] states with counties that experienced an average annual loss of $10 million or more from wildfire damage.
• 82 of the top 100 counties — ranked by highest insurance non-renewal rates – were coastal or low-lying delta counties

We also consider FEMA’s National Risk Index for Natural Hazards when surveilling individual credits. Naturally there is a high correlation between the Senate report and FEMA’s risk index.

The data that hurricane and wildfire-prone geographies have experienced higher rates of non-renewal isn’t necessarily groundbreaking, but it caught our attention and we will be adjusting our internal credit analysis to take this data into account. [We are happy to discuss this in more detail should you have any questions.]

The insurance information is especially noteworthy as this partially represents a region’s financial resiliency following a natural disaster. It also indicates higher insurance premiums which may dampen the local economy in the immediate future.

From the Senate report: An analysis of the Committee’s non-renewal data and the previously public premiums data shows a clear positive correlation between higher premiums and higher non-renewal rates.[4]

Lastly, it may be a sign that an area is underinsured or not insured at all. This would hold back a recovery (and hence tax revenues) following a disaster.

 

How does this impact our approach to portfolio management and credit analysis?

Most prominently, it gives us further confidence to concentrate portfolios in the Midwest and assurance in Texas’s financial resiliency due to relatively moderate non-renewal rates. On the cautious front, issuers within certain areas of California and Florida will be ascribed higher natural disaster risk within our credit analysis. North Carolina – with its significant coastline – requires greater risk as well.

In the chart above, Bernardi Asset Management’s High Income and Tactical Ladder strategies maintain significantly higher allocations to Midwest-states and little-to-no exposure to FL, CA and NY-based credits. The benchmarks – therefore index funds – allocate over 30% to the latter three states, which are the largest issuers in the market along with TX.  

For non-coastal investors who do not benefit from double exempt[5] bonds (e.g. CA, NY, NJ, MA residents), this is a further reason to allocate away from the benchmark (which is heavily invested in those states) and capture issuers that pay higher yields, in large part because they are excluded from that benchmark. Even so, for coastal investors, a partial allocation away from the coasts is warranted even if the bonds don’t offer double tax-exemption.

Ultimately, there are virtually no states immune to natural disaster risk in our country whether it be a potential drought in Iowa or earthquake in California. But it behooves investors to allocate away from the more disaster-prone areas. In our opinion it may be a win-win with both higher yields and higher credit resiliency.

If you have any questions, please contact your Investment Specialist or Portfolio Manager.

 

Sincerely,

 

Matt Bernardi

Sr. Vice President

 

 

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[1] Source: Bloomberg, S&P Global Ratings

[2] Source: Bloomberg

[3] Source: https://www.budget.senate.gov/imo/media/doc/next_to_fall_the_climate-driven_insurance_crisis_is_here__and_getting_worse.pdf

[4] https://www.budget.senate.gov/imo/media/doc/next_to_fall_the_climate-driven_insurance_crisis_is_here__and_getting_worse.pdf ; page 26

[5] Double tax-exempt meaning when a resident of a certain state purchases a bond issued by an in-state obligor. Oftentimes, these bonds are exempt from both state and federal income taxation. Certain states offer a high supply of these bonds such as CA, MA, NY, and NJ.

 

 

 

 

Disclosures: All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Past performance is no guarantee of future returns. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable.