Hurricanes and The Bottom Line
May 23rd, 2018
While it probably wasn’t forefront on the mind of your MUD Board while Harvey was hammering the coast, at some point in the aftermath you probably considered: how does something like this affect existing bonds, or our ability to get a new one for relief?
Just in case you are asking yourself, “what is a municipal bond?”, we’ve got you covered. A bond is a low-risk security usually issued by MUD to raise money for projects and water treatment facility maintenance. The issuer sells the bond to a holder, either a bank or local investor(s). The holder lends a fixed amount of money for a term in exchange for regularly scheduled interest payments. When the bond matures, the principal is due. Fairly simple. Bonds fall into one of two types: General Obligation, which is repaid through normal taxes or specific bond issues approved by voters, and Revenue bonds, repaid through funds generated by a funded project.
Almost half of municipal bonds are insured. An insurance company buys the bonds and resells them to investors. Insured municipal bonds carry a guarantee that even if the original bond issuer defaults, the insurance company will keep paying interest for the life of the bond, plus the principal at the maturity date. Insured bonds generally carry a lower interest rate than uninsured bonds for two reasons: the issuer has to pay a premium for the insurance coverage and the bond is considered less risky, even for an investment that's inherently very safe.
Of more importance to the topic, every bond has a rating. Moody’s Investors Services and Standard & Poor’s Corporation offer assessments of every municipal bond on the market; Fitch Ratings rounds out the “Big Three”. All three companies use a letter system to rate the relative security of investing in a municipal bond, the highest rating being AAA-equivalent (see image insert). Everything above BB is considered a fairly secure investment, while those below are considered speculative. Bonds with a C rating may already be in default.
Enter the Hurricane
Following twelve years without a major hurricane landfall in the United States, Hurricanes Harvey and Irma have left the Gulf Coast devastated. Both storms are expected to be among the most costly storms in U.S. history, with initial estimates for each storm exceeding $50 billion in damages. Texas took the brunt of the recent storms, but as a whole Texas has a fairly strong financial position. Texas is rated AAA by all three rating agencies; in terms of GDP by state, Texas ranked 2nd in the nation. However, while the credit quality at the state level is strong, smaller municipalities are more likely to feel the financial impacts of the storms. Given their smaller tax base, MUDs may be more sensitive to lower assessed values of property damaged by the storms. Lower property values would decrease the amount of taxes generated from ad valorem taxes on the property, and these are the taxes that typically support MUDs. Rounding out concerns, bond insurers may face additional claims as outlined by the S&P. These claims would likely be the result of extended power or communication outages causing electronic transfer problems for bond payments.
What this means is, through no fault of the MUD, there is the potential of a ratings decrease due to natural disasters. Events like Hurricane Harvey have sometimes unpredictable and long-lasting effects that affect repayment; long-term studies show that most bonds recover within six months, but that isn’t always guaranteed.
From the S&P Global site:
“There's no question the hurricane's devastation of the fourth-largest city in the U.S. could have a negative effect on the credit quality of various local government issuers, but it's too soon to tell.
“In the event of a natural disaster, we generally view the available federal, state, and insurance reimbursements as a credit positive because the total cost of expenditures related to the disaster will likely be fully mitigated. However, Harvey is the type of storm we see less frequently and it has quickly put itself on the same level as high-impact storms such as hurricanes Katrina, Rita and Ike. This means that, although some lesser-affected areas in Texas might fare reasonably well, the hardest hit will take years--potentially decades--to recover.”
Designed to provide utility service to housing developments, MUDs primarily collect property taxes and use them to pay debt service on bonds sold to build the infrastructure. With little overhead, MUDs also have limited cash flow beyond property tax receipts and utility taxes. As such, if a MUD experiences significant devastation, property and tax base loss, or makes late property tax payments, this could affect its financial operations. Although MUDs generally have segregated debt service funds, many MUDs do not have debt service reserves, potentially increasing challenges associated with making debt service payments in extraordinary situations. S&P continues:
“As Houston and its environs recover from flooding, the demands of rebuilding will present serious challenges. Although most natural disasters have a limited impact on our local government ratings and overall credit quality, an event such as Hurricane Harvey is more likely to have long-term ramifications. We have lowered ratings because of long-lasting economic and financial damage severe enough to revise our view of the long-term viability and composition of the local economies and tax and employment bases. Given the extent of Hurricane Harvey's damage so far, it's likely that some areas will experience this level of impact, but only time will tell. S&P Global Ratings will continue to monitor the effects of Hurricane Harvey as they unfold.”
Bad As It Sounds?
Many fixed-income investors might be wondering about credit risk and local municipal bond issuers’ ability to pay interest on time. If MUDs must pay for repairs, how can they afford to service their bondholders? It’s a reasonable concern, one that nearly always arises in the days following a major catastrophe. But the concern might be unwarranted, if the past is any indication.
According to credit ratings firm Moody’s Investors Service, natural disasters have not been the cause of a single default in U.S. muni bond history. Even Hurricane Katrina, responsible for a then-unprecedented $120 billion in damages, wasn’t enough to cause New Orleans to renege on its debt obligations. The reason for this is that the affected areas normally receive substantial disaster relief from both the federal and state governments. Congress appropriated tens of billions of dollars in aid following Hurricanes Katrina and Sandy, and this year it’s already approved an initial payment of $7.85 billion. Combined with flood insurance proceeds, this has often been enough to keep municipalities solvent and day-to-day operations running. Chances are, your MUD has already met to discuss FEMA and Insurance claims, or are planning to very soon. So, while ratings have dropped on municipal bonds for the short term (Houston as a whole is AA/Negative right now in the wake of Harvey), expectations are for ratings to rebound as the extent of damage to finances and revenue is fully realized. Of particular note, there has been very little trading of bonds issued by affected MUDs since Harvey hit, and the small lots of securities that have traded indicate it’s individual holders who are reacting. Lastly, bon insurers can provide an important stop-gap for smaller Texas municipalities that may be operationally challenged in this environment, by stepping in and making debt-service payments, but even that might not be necessary.
The Bottom Line
In general, ratings agencies are optimistic. As stated by a Fitch Ratings representative, “We expect most damaged property in affected communities to be rebuilt, which will maintain tax bases, rather than residents and businesses leaving the areas.” Check with your financial advisors about impacts to your particular MUD’s finances, reserves, and bonds. Hurricanes create temporary hardships on the communities that are impacted by them, but there is peace of mind; while it takes time, the areas affected by these disasters tend to make a full recovery.