Transcription:
Michael Scarchilli (00:05):
Hi everyone and welcome to The Bond Buyer Podcast, your go-to source for insights into public finance and infrastructure. I'm Mike Scarchilli, editor-in-chief of The Bond Buyer, and today we're taking a deep dive into the intersection of climate risk, municipal bonds, and market stability. Our senior director of Strategy and Content, Lynne Funk, is joined by Patrick Smith, senior director of muni evaluations at ICE Data Services. And Nick Peters, product director at ICE Data Services to discuss the market's reaction to the devastating Los Angeles wildfires. These fires triggered an investor led selloff in LA credits, particularly the LA Department of Water and Power bonds, marking one of the most pronounced climate related trading events in the muni market's history. Patrick and Nick will walk us through the market movements, credit impacts, and how ICE is leveraging data and analytics to track climate risk and municipal bonds. They'll also explore broader concerns around infrastructure, financing, the growing role of climate disclosure and what investors should watch for in the evolving muni landscape. So without further ado, let's jump into this critical conversation.
Lynne Funk (01:21):
Hello everyone and welcome again, I'm delighted to welcome our guests, Patrick Smith, senior Director of muni evaluations at ICE Data Services. And Nick Peters, product director at ICE Data Services. Welcome to you both.
Nick Peters (01:36):
Thanks for having us. Thank you.
Lynne Funk (01:39):
Excellent. So we're going to kind of just delve into this. After the devastating wildfires hit Los Angeles, there was a real market reaction and I think it's coming up to become one of the costliest natural disasters in US history. And of course, apart from the very tragic loss of life and property, the muni market saw the first kind of real investor led selloff of LA credits. Patrick, from your seat, why don't you walk the audience through the actual trading activity that you saw and how hard were the credits hit?
Patrick Smith (02:19):
Sure. Well, the most pronounced reaction was observed in the Los Angeles Department of Water and Power Bonds. As the fires started to progress, I think the market began to recognize that there was extensive damage far beyond anything that anybody had expected. And I think it was a Friday, maybe January the 10th, where the news coverage really started to pick up. And by Monday morning it was clear that this was a devastating situation, and immediately we saw the Los Angeles Department of Water and Power bonds start to trade off. Interestingly, because of California's high demand for tax-exempt paper, those bonds typically trade through our benchmark AAA curve, and beginning the morning of the 13th, they spiked right on up over a 60 basis points widening in the span of a day. It was very, very dramatic relative to what you might normally see in the muni market. Just typically very slow to react to news of any kind.
Lynne Funk (03:33):
Just thinking about that, that type of basis point move, I mean that's something we saw during COVID for the whole market. Of course, not one credit, but that type of move. So when you see something like that, that's really dramatic.
Patrick Smith (03:47):
Indeed and it's persisted, the bonds have stayed wide relative to the benchmarks, and I think that that's symptomatic of investors deciding that I need to be compensated for the risk involved in staying with these bonds. It still remains to be seen what the long-term ramifications are for LADWP. It could end up being quite expensive for them, one, to rebuild the infrastructure that was destroyed, but two, if they're found at fault for any part of this, there could be some liability issues and those knock on effects are demonstrated in the continued widening of the bonds.
Lynne Funk (04:27):
Right. We're going to probably get into a bit more of some of those ramifications for LA and for the broader market. But Nick, why don't you hop in here and can you talk a bit about the types of work that ICE has done in conjunction with your climate team to parse climate data and kind of probably set you all up to react to see how the market was reacting to this disaster?
Nick Peters (04:55):
Yeah, absolutely. It's been kind of like a three team collaboration between our reference data team that has our obligor data, the ultimate obligor of the underlying credit, the climate risk team, and then Patrick and his evaluation team. So putting those three content sets together, we started to really dig into the climate issues a little bit more. Over the past year we've identified using the climate risk data, a number of different municipalities, most of them being in the southern coastal states. And what we decided to do was use curves to essentially drive that analysis. Curves is a great tool for us here at ICE to be able to move a lot of bonds in sync because we all know that the number of instruments that are quoted and traded every day is much smaller than what is actually out there. So curves is a way that we can start to understand relationships between different credits and different use of proceeds.
(05:56):
So we built a curve and we primarily built it to get as apples to apples with our benchmark curves, both our AAA and our AA curves. So that means that we looked at general obligation bonds, we were primarily around the 5% coupon. We did anything that was non callable underneath 10 years. And then we started to track this. Essentially it was tracking right on top of where the AA curve was, which is primarily what most of those credits are rated. They're primarily aa that was telling us that the market wasn't on top of the qualitative feedback that we were getting from our clients, that this is not something that they actively take into account when they're going out there to make an investment decision. This is now also proven out within the data. So we start to track this and then we start to get through some natural events, right?
(06:45):
We saw hurricanes, Helene and Milton, and we started to look at the curve during there. There was still a muted effect, if anything, that we could attribute to a climate risk side of the curve. And then we also looked at some of the specific issues because there were issues in North Carolina that were put on credit watch, and for the most part, those didn't react all that much to that type of news when s and P came out with that statement. So when we saw this and we do have curves that are specifically built for the LA Department of Water and Power, it immediately could be seen by us and the evaluators. It is a little bit of a twofold thing for our evaluation staff because they are entirely reacting to the market and reflecting what the market is telling us, both from quotes and executions.
(07:37):
But once we start to see that on an aggregated effect, that's where the curves become a popular way for us to actually drill into that. And the interesting thing here was that the market moved before we all know that s and p came out and downgraded by two notches there, and I believe that was on the 14th, but the market seemed to actually react to that one quicker. And that was something as soon as we started to see that we started to then expand. Is this being more broadly seen? And that's still kind of what we're looking at right now is if there's going to be a broader impact to what we've currently seen with this very specific geographical impact.
Lynne Funk (08:19):
Interesting. And Patrick, maybe you can take us back to those other recent storms and weather events, Helene Milton, maybe go further back to Paradise Fire even further. Sandy Katrina, what happened then?
Patrick Smith (08:38):
I think the effects of those particular situations were muted because there are small issuers and not widely held. And I think in most cases the investors said they'll rebuild and we'll sit tight and see what happens. If you want to go back as far as Katrina, I think that in my memory is one of the events that had the most similar reaction in the market. And even then it was isolated to a few credits because at the time I was a portfolio manager and I was long New Orleans airport bonds and of course everyone thought that New Orleans was wiped off the map. And I come to work on Monday morning and I'm getting grilled by my partners. Why do we own these things? This is awful. We're going to lose a lot of money. And the bonds actually happen to be MBI and insured at the time, which then was a good thing.
(09:36):
So they dipped. They dipped a little bit, the ratings agencies did cut the underlying ratings, but the bonds had been issued to improve drainage at the airport. So actually was a good thing. Convention center bonds in New Orleans were a different story because that was in the news every day with all of the refugees piled into the convention center and the surrounding areas. It was a mess. And those bonds, even though I believe they were also insured, suffered draw down pretty quickly. Over time though, as it became apparent that New Orleans would rebuild all of those credits came back. So I think in this case, the Los Angeles bonds are so widely held and Department of Water and Power in particular is such a large issuer had to react. The market had to react. People had to look at their portfolios and say, I don't want to belong this headline risk and I don't want to have to explain this to my board or to my investors.
(10:41):
I'm just going to jettison these things. And I think that was the knee-jerk reaction that we saw the week of the 13th. And like I said, it's persisted, but the bonds have come back in and the situation has stabilized. And I think everyone realizes that Los Angeles, it's one of the biggest metropolitan areas, not just in our country, but in the world. And people are going to want to live there. They're going to rebuild the revenue base for water and power bonds might be impacted temporarily. It's going to come back. And yes, there's still some risk about who's liable, but there is insurance, however stretched thin it is. And I think DWA actually had some catastrophe bonds outstanding to help cover just this sort of instance. So I think eventually what you'll see is the bonds will come back in and they'll regain their previous ratings, although in this case it might take some time. This is quite a devastated area. It's going to take a long time to rebuild all those things, but it's going to happen. It will happen. So
Lynne Funk (11:54):
Thank you for that. I think it's an interesting time for sure. And when you think about, let's think about infrastructure generally, right? The needs that are out there and now you have the LA that's going to need to be rebuilt, and North Carolina, which has a lot of rebuilding. Some in the industry argue that there's actual needs for far outpaced the amount of issuance that governments and their entities are kind of willing to bring to market. Right now, last year, record year in the muni market, $500 plus billion. Some folks in the industry think we need upwards of $750 billion to a trillion even. And then you're going to bring in another layer of the very real threats to FEMA that we're hearing from out of Washington as it currently exists. I guess the first question is the willingness to rebuild and the ability to rebuild and the willingness to bring more debt to market. And how do we pay for all of this? How concerned should investors be? That was a lot of questions there. Who wants to take it?
Patrick Smith (13:16):
Well, I'll take a stab at that. It was a multilayered question. I think location is everything in real estate. People want to live in Asheville, North Carolina, people want to live in Los Angeles. Those areas were devastated, no question. And there is some uncertainty surrounding how much federal help they'll get in rebuilding. But even without that, those areas will get rebuilt. And I think as an investor, when you're looking at your portfolio of muni bonds, you want to think about is there risk in my base, my revenue base or my source of funds base that I should be more aware of, and am I being compensated appropriately for that risk? And if not, then I would suggest it's time to start doing some tax swapping something that we see at the end of the year every year. But perhaps this time people will take a closer look at their holdings and say, well, there's a little bit more environmental risk here than I'm comfortable with and I need to make some changes.
Lynne Funk (14:22):
Yeah, thank you. So I'll pivot over then to into, I think the underlying theme in this market is that it just has extremely low default rates. And to go back to your point, Patrick of Katrina Post-Katrina. New Orleans is here, it exists, it's stronger than it was before. This market has many security pledges, protections. But do you think LA was some tipping point of sorts, some cracks here in the market where we're seeing in terms of credit quality or perhaps credit pressure that hasn't been considered before? Is that part of this, perhaps that investors are really maybe taking a bigger look at what's under there? What's under the hood?
Patrick Smith (15:09):
I think it remains to be seen. I mean, currently it seems like the reaction is very localized to bonds that are connected to Los Angeles metropolitan areas. So yes, that includes the Department of Water and Power, USDs, community College Bonds, Southern Cal Public Power, Intermountain Power Agency and so on. Outside of that, we haven't seen any kind of environmental risk selling going on in other issuers or other parts of the country. And I think that's one of the things that, and Nick can probably speak to this better than me, but it's one of the things that's frustrated our environmental team for a long time. Like there's such disparity. Why are these bonds trading exactly the same? And I think that is a question that remains to be answered. What do you think, Nick?
Nick Peters (16:05):
I think where we're going to start to see whether this is going to be an impact or not is going to be coming from their rating agencies. If they are going to start looking at this when they're going to bring bonds to market or look at issuers that are out there and reaffirm their ratings or move them one way or the other, this is now probably going to be part of the equation. If you start looking at a climate risk and think of it like an unfunded liability and if you have to go out there and should something happen, what is the risk that that would go in? And it's probably going to be on the utility side, which is what we're seeing here. That's probably going to be one where they're going to have to go through probably a hardening cycle of trying to make sure that their infrastructure is resilient enough to take on a possibility of this event. And I think the credit agencies might be looking for that as well. So hopefully it was a great year for the muni market as far as the issuance, like you said. And even if you go out there with even a better year in the coming years, we're hoping that the market can absorb that at similar rates so that these companies can go out there and make the necessary changes that they need.
Lynne Funk (17:18):
And I have to wonder how much I'll say anecdotally from about a week, a week ago, actually the bomb buyer had an Outlook conference, and we had quite a few investors at the conference who did actually say they were thinking about it, climate risk and a severe weather event related risks a bit more. But as we also know, I think the buy-side in general is holds their cards to their chest very tightly. So we don't get to hear exactly how, but I'm about, let's look at this now. So we saw finally see a reaction to this in 2025. Trading's mostly stabilized, but the spreads are still widened, right? I mean, the damage has been done to LA to DWA at least. What's next here? Are there things that investors should be thinking about or looking for? Is there something specific that you all can point to in terms of data points about climate risk?
Nick Peters (18:21):
I don't know, Patrick, do you have something?
Patrick Smith (18:23):
Well, look, having been in this market for more than 30 years and having observed what can happen in this country, you have sort of the natural risks on both coast and also down South Houston, new Orleans, our primary targets for hurricanes Florida at constant risk of getting flattened by hurricanes. And I think you probably see the buy side put more pressure on issuers to disclose their climate risks and at least as much as they can, right? Because I think if you're a buyer of muni bonds, if you're buying Miami-Dade County bonds, there is potential for damage from a hurricane. If you're buying Miami airport bonds, there is potential for some long-term ramifications from a big storm that comes through. Sandy was a good case in point. A lot of people question the wisdom of rebuilding in some of the areas that were flattened by Sandy. And I think by and large, most of those areas did get rebuilt. I know at the Jersey shore where I like to vacation in the summer, everything new that came in was raised up seven or eight feet, maybe 10 feet, depending on where they are, was the requirement. Is that enough? I don't know. I don't know. I think it again remains to be seen. I hate to say that like three times in a row, but it does remains to be seen.
Lynne Funk (19:57):
It's true. Nick, did you have something you wanted to add there?
Nick Peters (20:01):
I think the other thing though, that investors are looking at, and I've heard this from a couple of people in the market, is that with the new administration to see what role FEMA is going to play in these events as we go forward, that's a lot of the ways that when I would go to talk to clients, especially before even the hurricanes last year, and asked them how are they thinking about climate risk? Most of the time I got a response back that the local government, the state, the federal government will come in and help out in some sort of way. There's insurance on the bonds, there are cap bonds that are out there. I have layers of protection that would have to take on the losses before they would actually hit my holding. And that was kind of how they rationalized the risk away. If we're going to start changing that equation, then investors are going to want more information about what these underlying risks are. So it's a little bit of a wait and see as we move forward in that regard.
Lynne Funk (21:01):
Right. I think the question that we often hear, and I have heard over the past few years in particular from issuers, is what am I going to see a pricing benefit from disclosing or providing more information or slapping a label on a bond? And so much now, I think the question might have to be flipped a little bit is when are you going to see a penalty if you don't do those things? And I think that's remains to be seen as what Patrick said, and a lot remains to be seen these days, but I think it's a really interesting time in this market. And as we know that there are the layers of protection and clearly our communities will be, should be rebuilt. But is there anything you think that I didn't ask either of you, that really we should be leaving this audience with in this discussion?
Patrick Smith (21:53):
Well, it's not that you didn't ask it, but just say it. If you're not looking at your municipal bond holdings from 30,000 feet, you should start, our environmental team has a map overlay of the country, and there are risk hotspots that you wouldn't think of in terms of flooding off the Mississippi. I mean storm surge all along, both coasts. These are things that if you're even vacationing in the Florida Keys, you should think about that. I think it was Milton, I was down there. I had to leave early because the storm was coming and you don't know what the situation will be. So I think you really need to look from 30,000 feet and pare down your risk if possible, especially if you're not getting compensated for it in terms of yield.
Lynne Funk (22:44):
Great. Alright, well I don't think this conversation's going to stop here. This is going to be ongoing, obviously, and I think it's really important and I really appreciate your insights and your time here. So I'll say to be continued, remains to be seen. There's a lot more to discuss. Oh, thank you both so much. We'll talk soon.
Michael Scarchilli (23:07):
Alright, pleasure. Thanks
Patrick Smith (23:08):
A lot. Thank you.
Michael Scarchilli (23:10):
We hope you enjoyed this episode of The Bond Buyer Podcast. A big thank you to Patrick Smith and Nick Peters of ICE Data Services for sharing their expertise on how climate risk is reshaping the municipal bond market. And to Lynne Funk for leading such an insightful discussion. Here are three key takeaways from today's episode. One, the Los Angeles wildfires prompted a rare investor led selloff in LA credits, particularly impacting LA DWP bonds signaling heightened market sensitivity to climate risks. Two, data-driven approaches like those employed by ICE are becoming essential for tracking climate related risks and understanding market reactions in real time. And three, as infrastructure demands grow and the impact of severe weather events becomes more frequent, issuers may face increasing pressure to disclose climate risk and resilience planning, or risk seeing a penalty in the market. Thanks again for listening to The Bond Buyer Podcast. This episode was produced by The Bond Buyer. If you liked what you heard, please hit subscribe on your favorite podcast platform. Leave us a review and check out our latest coverage@www.bombbuyer.com. Until next time, I'm Mike Scarchilli signing off.