Muni market climate risk: Hidden perils, untapped opportunities

We believe the risks and opportunities associated with climate change should be part of the “mosaic” for how insurers approach the municipal bond market — and that now is the time to act.

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. Your capital may be at risk.

KEY POINTS

  • In our view, climate change represents an acknowledged, yet still underappreciated, risk in the municipal (muni) bond market, but also presents investment opportunities for active managers.
  • We believe this risk should become part of the “mosaic” for how institutional investors approach the asset class — ideally sooner rather than later.
  • For insurers, we believe having a diversified asset/liability mix, while very important, may not sufficiently mitigate potential portfolio losses related to climate risk.
  • Given the risk of material climate impacts on certain municipalities, insurers may want to rethink their long-term assumptions on the asset class, particularly for credits in vulnerable areas.
  • Insurers might consider:
    – making substitution trades for inefficiently priced municipal issues; and
    – diversifying their climate risk exposure (while maintaining favorable legacy book yields).

INSURANCE COMPANIES ARE KEENLY AWARE OF HOW TO ASSESS, PRICE, AND DIVERSIFY RISKS ASSOCIATED WITH THEIR LIABILITIES. But forward-looking issues like climate change, with little or no historical precedent, may pose a vexing challenge for their traditional methods of underwriting risk. And the same climate risk issues could also negatively impact the asset side of insurers’ balance sheets. For example, municipalities in climate-sensitive regions are particularly vulnerable if/when their tax revenues decline as their citizens and businesses emigrate to lower-risk climates. We think these risks will play out, and perhaps intensify, over a number of years as the adverse impacts of climate change increase in frequency and severity.

As the threat of climate change grows and losses mount, insurance companies may face the potential “double whammy” of also incurring losses on their municipal (muni) bond portfolios at the same time as their insured losses increase. (While climate change is clearly a global matter, this paper focuses exclusively on US projections and the potential impact on the muni bond market.)

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