Whether it’s the draughts in California or hurricanes in the southeast parts of the United States, natural disasters can cost hundreds of lives and billions of dollars in damage to the economy. According to the National Center for Environmental Information (NOAA), the past few years have had the record-setting “Billion-Dollar Disaster Events,” both in frequency and the total financial detriments to the American economy.
Given the increasing frequency, these events can create an enormous financial and resource burden on both the local and state governments. Most of the financial burden is often shared by local, state and federal governments in their relief and reestablishment programs.
These natural disasters can also severely impact the revenue streams for cities and counties around the United States. In this article, we will take a closer look at how natural disasters can potentially create an unbearable burden on financial operations for local government, ultimately impacting your holding of municipal debt instruments.
Be sure to check out our Education section to learn more about municipal bonds.
Understanding the Bond Covenants
Before making the final decision of purchasing an investment instrument, investors often analyze the debt covenants to understand the potential financial restriction placed on the municipal issuer and certain financial measures the issuer would be adhering to meet all the requirements of raising the capital.
In revenue-backed debt, which finances income-producing projects and is secured by a specific revenue source, there are established agreements called Rate Covenants that require the issuer to maintain certain financial ratios on the debt. These types of bonds are generally issued to finance water, wastewater, stormwater plants, electricity power plants, airports and other revenue-generating projects.
Click here to learn more about essential service revenue bonds.
The revenue generated from these plants, which is often based on the service usage and unit rates, is used to meet the debt service payments. Now, before issuing this debt, there may be an agreement/covenant drafted as part of the transaction that will bind the issuer into maintaining a certain level of revenues, to provide a sense of security for investor and to ensure that the project will generate enough revenue to make the bond payments. For example, the issuer may be required to maintain 10% revenue buffer after all the operational expenses and debt service is met, which means that if the yearly revenue is $110 million dollars from a project, the issuer’s total expenses cannot exceed $100 million dollars.
A valid question may be asked: What happens when the revenues decrease or expenses increase?
If the revenue is decreased by so much that the issuer is no longer meeting its 110% revenue requirement or expenses have increased too much, the issuer may look to increase its service charge (rate/usage) to ensure that it’s meeting the coverage requirements.
Use our Screener tool to find the right municipal bonds for your portfolio. You can also select the states that might issue your municipal bonds of interest.
Natural Disasters and Rate Covenants on Your Debt Holdings
Natural disasters often play an integral role in severely impacting the revenue streams of various revenue-backed debt. A good example of this emerged out of California during the 2013-14 draughts when Gov. Jerry Brown declared a state of emergency due to water shortfall and requested California residents to voluntarily reduce water usage by 20 percent.
Now, some may think that urging state residents to reduce water consumption is a great step towards water conservation and saving the environment. And, it is. However, the local governments rely heavily on a certain amount of water consumption by its citizens to generate enough revenue that will back the outstanding debt levels. Since the rate levels are constant, the increase and decrease in water consumption will have an impact on the revenues. When Gov. Brown announced a state of emergency and urged residents to conserve water, the water consumption levels fell at the local government levels prompting many local governments to raise their water rates to meet their revenue levels and, ultimately, meet the promised debt covenants.
Amongst other critical areas, rate covenants are very closely monitored by the rating agencies that are assigning their ratings on these bonds. If these debt covenants are not met or proper steps are not taken by the municipality to meet these covenants, it will have negative effects on the rating of that particular issue.
Key Considerations for Investors
Before you decide to invest, it’s critical to understand the revenue source backing your debt instruments and how certain changes in the market and natural events can have an impact on your holdings. For instance, consider these two cases:
- Revenue bonds are backed by revenue streams from critical services provided by utilities, meaning these revenues are not part of a city’s general fund or commingled in any way. Also, each utility is treated like its own business, so there are bond covenants that must be met.
- On the other hand, the vulnerability of tax-backed GO bonds was exposed during the recent financial crisis. As foreclosures reached an all-time high, property tax revenue was cut, leading to several municipality defaults.
Click here to learn more about conducting appropriate due diligence before making an investment in municipal bonds.
The Bottom Line
Where both revenue bonds and GO bonds provide stable income and diversification for an investor portfolio at relative risk, it’s imperative to understand the complete structure of net revenue pledges and what can affect these revenues.
A simple comparison can be made with this statement: If an individual loses his job in an economic downturn, would he or she be more likely to pay his water and sewer bill or make his property tax payment? Investors must understand the intricacies of both debts along with the understanding of the pledged revenues and credit characteristics of the issuer.
Sign up for our free newsletter to get the latest news on municipal bonds delivered to your inbox.
Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.