The Future of Municipal Bonds: Climate Change and Market Implications

Hi, I'm Jeff Gitterman.

Thanks for joining us as we explore how to best take advantage of changing times and shifting markets.

Today I'm joined by Tom Doe, CEO of Municipal Market Analytics, an independent research firm providing strategic analysis and insights on the US municipal bond market, including climates. on pricing and credit.

Tom, thanks for joining me today.

Jeff, a pleasure to be here with you.

So this is my favorite topic because I've been talking to people about this for 10 years and I feel like now I have the industry expert in front of me.

I'm almost like at a loss for words at this point, but I, we could just start by the fact that for 10 years I've been asking people why the municipal markets aren't pricing in climate risk.

Maybe you could finally give me the answer to that question.

Well, I'm sorry, it's all about denial, but the just the river in Egypt.

The big thing is that the market has just believed that climate is not a material event to the payment of the bonds.

And so as a result everyone has just been in denial with it and they've also, the investors have after the repeated weather events, hurricanes, let's per se, and Katrina in New Orleans, tornadoes this weekend, yes, but in the past, the municipal market has always believed that FEMA would bail them out.

In that case, that was always the case.

Federal money would come in.

And restore the community and provide a situation of economic vibrancy, bonds would appreciate in price, and we go on to the next day everyone made out from weather issues, which is a terrible thing, correct, but it was a federal support and that, as we've talked about is and we've all seen in the headlines, is that now FEMA may not be there.

And I think this is a huge, huge event for the municipal bond industry because we won't have that backstop.

It seems like a Minsk moment, like that moment in the market where you weren't prepared for that particular then.

I'm curious too because it's not just that at the same time that we have that kind of hanging over our heads a little bit, you also have all of this new data that is coming to the end consumer, whether it's through Street Risk or Street Easy or Zilla.

So about where their risk is in buying a home that wasn't around really up until late last year wasn't really available to people.

We're already starting to see from that data some moving patterns around lower risk flood areas where people are not wanting to move or they're pricing higher for higher elevation.

So I feel like you've got this squeeze about to happen in the municipal markets where Clients and clients and homeowners have this data and FEMA might be backing off.

Are you hearing any sense from either municipal bond rating agencies or from municipal bond issuers that they're starting to get concerned about all of this?

The concern is arising and so as I was mentioning the word materiality, which is very important to bond attorneys who are creating the documents that accommodate the issuing of debt by a state and local government.

And those bond attorneys have always said again climate wasn't material to the repayment of the bonds, but the rating agencies, as you know, rating agencies have bought climate data companies and now are stating that they are incorporating climate data into their measurements of credit worthiness.

And just last week, the National Federation of Municipal Analysts had numerous panels on the subject.

And now what's interesting is that since the rating agencies are looking at climate data, now that's creating a material event.

So now the bond attorneys, because the rating agencies are now voicing that they're utilizing this data, it's material that is a big step and it's a very subtle one.

But also how we're seeing seeing this appear in the municipal industry is that portfolio managers are now armed with data.

Much like First Street is providing, and they're now able to review their portfolios and assess which of their bonds have the highest degree of climate risk.

Our hosts here of ICE, who on the New York Stock Exchange, have a.

Data company that is being provided to portfolio managers and just in my conversations last week with the portfolio manager who oversees portfolios separate managed accounts so might have 20 or 30 line items.

He is now assessing what the risks are of those bonds from a climate perspective, and what he has discovered in the secondary market is that when he needs to raise money for his client and he needs to sell some of those bonds to raise the cash, is that he's binding for some segments of the market that instead of having 12 bids for the bonds, he might have 4.

That's still the price hasn't changed.

It's a 75% drop in liquidity, and liquidity becomes a very important element, as you well know, from your clients.

People like to get their money back at a reasonable price or at the price that they perceived from the prior nights of evaluation for their bonds.

So that's a very important element.

That's occurred.

The other thing coming back to 1st Street with mortgages and real estate, so 20 to 30% of the municipal bonds are general obligation bonds and most general obligation bonds are are paid for by property tax revenue, right?

So if we start Seeing residential real estate, commercial real estate, start to decline in value because there's a higher climate sensitivity.

We're seeing such things happening in Florida.

Oh for sure, 40% drop in condo values, HOA fees going up and discouraging people from buying condos, which is weighing on that market.

Some of the climate affected at risk areas we're seeing home insurance increase the premiums increasing 400%, so we all read the acquisitions of Palm Beach real estate and someone pays $100 million for it, but the people that are inland and then 90 probably.

5% of the residents in Florida are feeling the impact of climate change and the value of their properties, the liquidity of their properties, and I think that becomes a very important thing that the municipal market is starting to be aware of.

But 30% of a $4 trillion market that's at risk climate, that's a big deal.

Yeah, talk to me.

Let's take a step backwards a little bit.

Look at something like the LA fires where Everyone seems to have come out now and known that the risk of the fires in LA were off the charts.

I mean, every risk company and weather risk company out there shows that they have predictive analysis that that particular area in LA was.

Incredibly prone to fire risk, yet municipal bond markets priced in really nothing around that risk.

What happened after the fires?

So really the only credit that was impacted was Los Angeles Department of Water and Power.

And there's the power companies, the electric utilities are a little bit nuanced because a lot of the price decline around those credits is tied to the risk of future liability for those wildfires, but this is what I think is important about that is that LADWOP, as it's called, it's their yields increased by 60 basis points after.

Not only the wildfire, the event, but also Standard and Poor's downgrading the credit, and I give Standard and Poor's a great deal acknowledge that they stepped ahead of their competitors to downgrade it.

It would have been great if they had done it in a proactive way before the event, but they stepped forward when it occurred.

And since that time, that initial 60 basis points.

Almost more than 0.5%.

I always have to remember thinking about basis points.

I was with during the financial crisis with Barney Frank down in DC, and he said, Well, what's happening in the municipal market?

And I said, Well, it's incredibly volatile.

He said, What do you mean by that?

And I said, Well, let's move 10 basis points.

He said, my constituents only care when it's a 0.5% or 4%.

And because it's a mortgage kind of rate, but anyway, so that Los Angeles credit did increase more than 0.5%, and that that increase in yield has been sustained and that's important.

So I think one way to look at the municipal market if you have issues that are at risk is that there's a 60 basis point.

Risk that's not being evident in today's pricing, and because that's not being priced in proactively, we're big proponents that state and local governments and the agencies and authorities should be tapping the raising capital now for climate adaptation projects.

So for example, I was on a panel last week with an analyst from Standard and Poor's.

And we were talking about the aging infrastructure in Memphis, Tennessee that's being their water and sewer Authority is being strained by the volatile weather, increased flooding, all this type of thing, and he said they've downgraded the credit and I asked him on the panel, he said, had they borrowed to improve their infrastructure.

Would you have downgraded it, he said we probably would have held the credit stable.

Wow, wow.

That's an important message.

Yes, but that's an important message for the rating agencies to be saying it's OK to borrow if you're part of your, if you're acknowledging that forward risk, then it's good to spend the dollars now, especially when the market's not penalizing you for the risk that's that's easily quantifiable.

It's interesting because a lot of the rating agencies have value at risk of climate VAR scores, but and you said earlier in your remarks that you're starting to see a trickle into the credit rating, but we've seen where a rating agency could have like a D rating or a very low, very high value at risk for a specific bond, but that bond still has a AAA rating from the same rating agency.

So and this has been going on at least 7-8 years where some of these rating agencies have had VAR scores.

It's fascinating to me that you can have two scores at the same company that almost contradict each other.

Do you see them really starting to merge in incrementally, but again, it's the whole thing who moves first?

And if the municipal investor, and now I'm not talking. about your clients, the individual, but the institutional investor, if they're not sensitive to the climate risk, then they're not going to press the rating agency.

They're also not, they're still going to pay a higher they'll they'll want to buy that bond with a higher yield because they're still betting the bond's not going to default.

And so the history of low default rates in the municipal industry is somewhat creating a Moral hazard to take the appropriate action to measure the risk and incorporate that risk in day to day portfolio management.

And the other part of that, as you well know, a lot of your investors who allocate money to municipal bonds are looking for income.

They're not looking for performance, so that fluctuation that might occur on a price basis because of, say, a climate risk, as long as that income is being paid out.

Then unfortunately not you, but others in say the high yield space of municipals are willing to take that risk to provide that income to their clients and so that risk is out there in our industry and it's a great concern and I think what's going to happen is that there will be an event and maybe it's the FEMA not being there, that will, when we have a disaster which we know we'll have.

That will be really a true tipping point that in the wake of the LA fires will awaken the market in a place that it has never done before.

So how can an investor who's concerned about this risk start to take seriously and price in some of the risk from their viewpoint?

Well, I think one is that you should be talking with your manager about how they rated, have they scored your portfolio and evaluated on a risk.

There is no for climate risk.

There's no excuse that the answer should be no, and I mean, frankly, I mean the largest holders of municipal bonds, the largest funds are doing embarrassingly little in terms of climate.

So I think if you're in a mutual fund, a large ETF is there's so many line items that's just trying to index the market, that manager really has no incentive to to be.

To be sensitive to that climate risk, I think as we were talking a little before is that separately managed account manager who is client facing and that client will see the headline from the weather.

Volatility and the events over the weekend and they're occurring today in the Midwest will start to ask that question.

So the first step is, is your is your manager reviewing your holdings and able to tell you what's at risk or not give a climate.

And again, using our friends here at ICE, it's very easy to get access to that information or they can also be done by using FEMA data, as long as FEMA exists, but I think that's a it's out there.

So I think first just ask your manager, you're paying a fee, demand that information and then also simply look at 1st Street and and look at the residential real estate, look at the risks associated with real estate, residential real estate in the areas where the bonds you own.

It's interesting because it goes back to the point you made about municipalities can act early and start issuing debt.

Or rebuilding and re infrastructure build out and infrastructure renewal, we always think about the same thing for the end investor.

The end investor right now has a risk-free rate for non-climate exposed bonds as compared to climate exposed bonds.

So the investor right now could kind of call their portfolio, especially if it's an SMA or if they're purchasing individual bonds they can.

Call their portfolio using the value at risk scores of an IE or Moody's or someone out there and not drop anything in the yield because you can buy a AAA hospital bond in Tampa that has a value at risk of 80% or you can buy a AAA bond in Rochester, New York that has a value at risk of 8%.

So basically 872. less risk from climate get the same yield, same maturity, same AAA rating.

So it behooves the investor to act before there's a crisis because there's no cost to acting.

That's exactly right.

So there's liquidity, but to my point earlier with this one portfolio manager that I was talking with, he is finding that there are fewer bids.

So I think it's a time.

Time is of the essence to review your portfolio today, and, and take advantage of this liquidity opportunity that exists and improve your portfolio essentially weatherproof your portfolio so that you can sleep better at night and derive the opportunity for that income.

And the reason why that liquidity is especially there is that the municipal investors over the last two years. have become enamored with the higher yield from high yield securities, but they're really not being paid again for not just climate risk for any of the risk that's being taken, especially on longer maturing bonds.

And so there's been this great demand and a high yield manager will tell you that there's no risk, right, which is your performs talking their book at that point, but that's what's also creating the liquidity and So again, weatherproof your portfolio.

Well, Milken said, there's the thing about liquidity, it's always there when you don't need it, and it's never there when you do need it.

So that's something to do with we do credit reviews for banks often and for their investment portfolio, their municipal bonds, and it's always amazing that they're always asking the question after the credit event, right?

Oh, what do I do now even though you forewarned. and because I couldn't disrupt my portfolio because I love the yield.

We have a client who's an institutional high net worth investor, SMA accounts.

He said he asked me a year ago, what's what's what's what's the risk you're paying attention to aside from climate which he was aware of?

I said California to me poses a great deal of risk, and he said, Well, I can't.

I can't act on that.

I said why not?

I said 50% of my business is in California, yeah.

Well, you know that that's your problem, your investors should be making investors aware of that.

So when we have areas of the country and California's got their budget issues and they have climate issues as well and migration issues, is that it's the period of Of credit stability is coming to an end, and it's been not just the last 10 years, but you could almost say the entire history of the municipal bond market, or at least probably not since the New York City crisis in 1970s which gave the birth of mutual funds and diversified portfolios, is is now has come to an end and it's much like our friend Spencer Glendon who talks about the era of climate stability changing to instability and I think There's there's an analogy there and and both are tied at the hip as as being unusual periods of time that are now changing, and investors need to change their perspective and toward their holdings.

Yeah, and I remember hearing him 5 years ago, maybe 6 years ago, when someone was asking about when should I sell my Florida real estate, and he said, Well, when everyone's asking when, when it's when it's going to be too late, which It is always the point that you have an opportunity to kind of act now on some of these risks, do it before the risks take over and it's too late and it's already priced in.

I just want to finish on the fact that something that is glossed over a lot.

A lot of the communities that are most at risk from a weather standpoint and then also from a climate migration standpoint are disadvantaged communities where you have a very wealthy community.

A lot of times it's people.

2nd or 3rd home.

The real estate values somehow like in California or people are paying 10% premiums for houses that probably can't get insured anymore.

It's insane.

But in disadvantaged communities, you don't have that opportunity.

What are municipalities that are at risk in those areas thinking about from a municipal bond and a municipal risk perspective?

This is a travesty, truly in that.

You know, over the years and you even look at Robert Moses, who's built New York City and planned New York City, was really guilty of putting Disadvantaged People in the areas of greater climate risk, and that was decades ago that all occurred.

But those communities are is that's a real challenge not just for the municipal market but also for us as a society, as people are disadvantaged, they can't move and we all know it's emotionally hard to move anyway, even if you know those things, but um.

And also because their economies are not strong, they're already paying a high interest rate in order to borrow capital in order to make sure they have clean water or that there's appropriate housing or that there's appropriate utilities, electricity, and all this.

So I don't have a solution there.

The market doesn't have a solution.

And so that's a growing problem.

Um, there's a wonderful book about Charleston, South Carolina, written by a woman who I've come to know at the Carnegie Foundation named Susan Crawford, who outlines, you know, Charleston, South Carolina is referred to as the um Uh, they call the Confederate Disneyland, but looking at how that city is is not acknowledging the climate risk, flooding more and more all the time, and how people have been moved to the disadvantaged people have been moved to areas of even greater climate risk and this is just in the last 20 years is persisting and so everyone goes down there and it's Charleston's considered one of the great cities of our country and yet That's fine for a small percent of the people who live there, but otherwise it's a huge problem and one that's going to be, there's going to be a day of reckoning that is going to be very uncomfortable.

Do you start feeling like the boy that cried wolf, because I know I do.

Does that hit you at all that we've been talking about these problems for years.

They're really starting to manifest in a way that I don't think even we who were watching this area expected this quick, and yet people are still kind of have their head in the sand in a lot of ways.

I admire you for how long you've been focused on this issue longer than I have, and I then even look at the people that have been on this even beyond been spending 30 or 40 years of their careers focused on it and the frustration that has manifested.

Well, actually that hasn't manifested among a lot of these people who are just fighting the good fight and I think one of the things that we really could use as a country right as a federal policy and we missed.

I guess we're probably going to miss this next 4 years.

The last 8 years we also lost even during the Biden administration, too much focus on mitigation, meaning trying to cool the planet and carbon capture and alternative energies, which are all meritorious.

But in the meantime we have to adapt to the changing climate that we have now and shoring up infrastructure and having those conversations about it, and I think.

The big thing that I'm trying to push and you're trying to push is to have people who are involved in the capital markets who are who are who are key to financing these projects that they are willing, they don't fear that they're going to lose business if they have a conversation about it and that's what we have to keep encouraging people and fight the good fight.

Tom, thanks so much for being on the show today.

My pleasure.

Thank you, Jeff.

Thanks again for spending time with us as we continue looking at new solutions and innovative ideas always from the floor of the New York Stock Exchange.