Tuesday, January 25 2022

From forest fires to floods, from hurricanes to heat, the effects of climate change on our communities are well known and are expected to worsen.

But as participants in the municipal debt market are starting to realize, there are no bond vigilantes to impose discipline on state and local government issuers. A new study confirms this notion, showing that investors have yet to begin charging a premium for bonds that could be more at risk due to extreme weather conditions.

This means that as weather conditions become more volatile, things may have to change: either municipalities will pay more to borrow, or state governments and Washington could increasingly foot the bill for bondholders. are unharmed.

The report, from climate analysis firm RisQ, Inc. analyzed the returns of about 800,000 municipal bonds issued between 2006 and 2021, representing about $ 2.5 trillion of the $ 3.9 trillion in circulation. “This is a time,” the report notes, “when it is reasonable to assume that climate risk was widely recognized as a potential problem.”

Previous coverage: Climate risk hits states and local governments

The research process involved making an estimate of the expected return on all bonds in the dataset, based on factors known to influence the return, such as the duration of the bond, type of issuer, etc. . He omitted climate risk as an input. Next, the researchers superimposed a bond-exclusive climate risk score, demonstrating that there is no correlation between climate and any additional risk premium for bonds that was not explained by the other factors.

Source: risQ, Inc.


The researchers then rerun the same model, using only bonds issued between 2017 and 2021, noting that “physical climate risk came to the forefront of collective market awareness following the hurricane season of 2017.” , which remains the most expensive ever recorded.

But they come to the same conclusion with the second experiment: the climate does not influence the yields.

In addition to the data analysis they perform, risQ ​​analysts have important points to remember about why the municipal market has not yet taken climate risk into account.

Among them is the old saying that muni bonds rarely fail. As they note, “compared to other asset classes, municipal bonds have indeed historically been less risky. For this reason, systemic risk in general (weather and otherwise) has not been as central a concern for the world and culture of municipal bonds as it has been for the insurance or mortgage-backed securities markets. “

Another is the belief that the climate has not historically caused defaults, an argument “that we hear less and less as the climate crisis worsens,” the report notes. They call climate risk “a ‘frog in a pot of boiling water’ situation, in which the systemic risk is drastically underestimated, and the heat will increase at least gradually, and possibly abruptly.

What does this mean for investors?

Among other things, risQ ​​repeats some of the themes that MarketWatch has touched on in recent months: Investors should be aware that the municipal market can present risks camouflaged by unbalanced supply and demand, issuers with little incentive (so far). to disclose their challenges, and rating agencies and regulators who may not be as proactive as necessary.

The risQ ​​report ends with an example of a recent climate catastrophe: the Paradise fire in California in 2018, where nearly 90% of the city was destroyed and 90% of the population forced to leave. Despite this, Paradise was able to pay off its bondholders, both because of state law that allowed California to step in and make up the payments, and because the state was able to obtain direct federal assistance. .

As MarketWatch has previously reported, some observers believe the municipal market may not be able to continue to rely on state and federal bailouts, particularly as “centennial” weather events occur each year. . By the time the frog realizes it is in hot water, in other words, it may be too late.

“Bond issuers will have to prepare for a possible ‘sticker shock’ in many cases – yields do not yet reflect climate risk, but it’s almost certainly a question of when, not if,” writes risQ. But the sooner they take proactive action, the better: tackling the problem is not only good for the whole market, but is also seen as “positive credit.”

Read more : Cities and states on the front lines of climate change are not always upfront about the risks. Does the municipal bond market care?

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