Rising property insurance rates a red flag for looming muni market shifts

Property insurers’ growing reluctance to insure homes exposed to severe weather should raise a red flag for the municipal bond market, which so far has shrugged off risks but will soon have to grapple with major climate-driven shifts in credit quality and bond prices.

That’s according to panelists who spoke Thursday during a webinar titled “The property insurance crisis & beyond: how climate risk can affect municipal credit quality,” hosted by DPC Data.  

The real estate market is beginning to price in climate risk, with premiums rising — driving down property values — and some properties becoming uninsurable, said Jeremy Porter, head of climate implications research at The First Street Foundation, which tracks climate’s impact on real estate.

“This is the first industry to begin pricing climate into the market and we are in the very early stages of that process,” Porter said. The “hidden climate risk is starting to be uncovered and beginning to be priced into the real estate market through increasing insurance premiums.”

Rising premiums and declining values are causing the initial cracks in municipal credit, panelists said.

“Insurance rationing by the leading insurers is becoming the mechanism by which climate risk is starting to impact municipal issuers,” said Triet Nguyen, vice president of strategic data operations at DPC Data, who moderated the panel. The muni market, Nguyen added, “doesn’t have a great record in terms of discounting these major changes.”

Despite a rise in extreme weather events affecting cities and states and more focus from investors and regulators, muni bonds have yet to show climate-driven pricing differences. But that could change quickly, panelists said.

“Over the next two years or so we’re going to see a muni market that takes climate change much more seriously and that means changes in relative valuation,” said George Friedlander, longtime muni strategist and CEO of George Friedlander & Associates.

That means wider credit spreads and a steeper yield curve, trends that will be accelerated by a shifting buyer base toward more individuals investing through separately managed accounts, Friedlander said.

“We need the market to take relative valuation and the [climate] risks much more seriously and that’s going to come in part as individual investors become an increasingly dominant source of demand,” he said.

The high-yield muni market in particular could “take it in the neck in terms of widening out significantly,” Friedlander said. “Major weather events that affect local conditions will be extremely damaging to credit and that’s going to push more issuers into that high-yield category, and I don’t think it’s going to take long for us to get there.”

The current market “indifference” to climate risk presents an investor opportunity, said Derek Endsley, a senior analyst in the credit research group at Loomis Sayles.

“That misunderstanding of risk [in valuation] is an opportunity for our clients – our longer term hypothesis is for the market to incorporate the risk,” Endsley said.

As private insurance companies become more cautious, the space is seeing some new models, including states having to step in to provide insurance.

That raises questions of whether large public plans could begin to impact state credit, Endsley said.

Columbus, Ohio city auditor Megan Kilgore, who testified in January at a Senate Budget Committee hearing on how weather affects the muni market, said a state-created plan “shifts the burden of responsibility to the residents, to our taxpayers, either through taxes or borrowing,” she said. “So, who is ultimately paying for the consequences of climate change?”

The Securities and Exchange Commission’s new climate disclosure rules for public companies will eventually filter down to the muni market, panelists said, and the market would do well to get ahead of the trend.

“It’s fair to ask what can be transferred over to the muni market,” Kilgore said of the new rules. “There’s a period of evolution right now,” in terms of how issuers disclose climate risk, she said. “As a debt issuer, we do seek standardization and simplification to make sure we’re doing it correctly.”

For investors, issuers that have “married their capital plans with their climate outlooks tend to be more positively viewed in the institutional space but you’re going to see disclosure across the gamut from very robust to nonexistent,” said Endsley. “We want as much standardization as we can get from our issuers,” he said, adding that it’s “probably not a realistic goal in the next few years given the lack of guidance that issuers receive.”

Nguyen said it would be “optimal” for the market to reach an agreement on disclosure standards. “I’m hoping the industry will coalesce around some type of disclosure on a preemptive basis — some recognition of the risk and match it up with how an issuer is addressing this risk; that combination is what the market should be looking for.”

As more states and local governments embark on capital projects to mitigate climate risks, the question of funding will be key, Friedlander said. Though some participants argue that the municipal market will play a major financing role, Friedlander said he is not so sure.

“I don’t think that state and local governments are going to have the revenue sources necessary to do the things needed,” he said. “The federal government is going to have to get a lot more involved and we as an industry are going to have to get them more involved.”