CONTRIBUTORS
Ben Barber, CFA
Director, Municipal Bonds,
Franklin Templeton Fixed Income
Jennifer Johnston
Director of Research, Municipal Bonds,
Franklin Templeton Fixed Income
First, we would like to express our deepest sympathy for those affected by the wildfires in California. We also need to acknowledge the long-term process of assessing damage and rebuilding, which will likely take months if not years.
As municipal (muni) bond research analysts, we are seeing many muni issuers in the affected areas. The impact on each will be different and unique. Generally speaking, we think that insurance combined with state and federal assistance will enable these communities to rebuild. While we could see downgrades, we do not expect any defaults by governmental issuers.
As we think about the impact to muni credit, we have some initial thoughts:
- One of the biggest impacts from natural disasters to muni issuers is usually related to (property) tax base declines. However, the Pacific Palisades fire, one of the most destructive in the area, is only a small part of the very diverse areas within greater Los Angeles. As a result, we don’t think that city revenues should sustain any significant reduction from the damage, nor do we predict issues regarding the repayment of city or county debt.
- Despite the ongoing headlines about insurance challenges in California, we remain confident that insurance companies will be able to meet the needs of their policyholders. Over the medium term, however, this could mean higher premiums.
- In our opinion, the biggest financial risk may be to the entities found at fault for the fires, with the possibility of short-term credit rating downgrades. At the moment, we expect much of the focus to center around the public utilities, most notably the Los Angeles Department of Water and Power, Southern California Edison and the Southern California Public Power Authority. The first has already seen a credit rating downgrade from S&P Global.
- A key to recovery is going to be insurance, as well as federal and state support, all of which have historically helped communities to rebuild. In fact, once this begins, local economies tend to see improvements, with examples including an increase of construction jobs or rising tax collections from the sale of construction materials.
The fires in California have caused unprecedented damage and pose significant challenges. From a muni bond investor’s perspective, it is important to note that the diverse economic tax base and the strong legal protections built into many muni bonds provide a buffer against severe financial impacts. Although there may be short-term credit rating downgrades and increased insurance costs, the long-term outlook remains cautiously optimistic.
The focus now is on recovery and rebuilding. The hope is that these efforts will ultimately lead to economic improvement and community resilience, as we have seen through disaster situations in the past.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.