Municipal bonds are enjoying a surge of demand. Everybody from pension funds and insurers to mutual funds has sought out the instruments in order to wring out a little more yield than the anorexic returns provided by the debt of many central governments. And they are doing this while enjoying tax-free status on many of the instruments.

Cities in the US have been quick to take advantage of this demand, which led to the municipal bond market hitting over $400 billion in new issuance during 2019, according to a report by Bond Buyer, a 27% rise on the previous year. While Refinitiv Lipper said that investors put a record $94.05 billion into US municipal bond funds last year.

Asian institutional investors have been part of this demand. One head of regional institutional client coverage at a US asset manager told AsianInvestor that municipal bond mandates proved to be very popular with Korea-based institutional investors during 2019. 

But as appealing as these instruments have been, they now face a new array of risks to their valuations. Investors are fairly familiar with interest rate shifts or economic slowdowns, but what about the danger of super-storms tearing down electricity pylons and flooding streets? How about the risks of internet hackers holding city government records hostage?

Welcome to 21st century investment risks.

As investors cast around for increased yield in a low rate environment they are turning to areas such as municipal bonds and infrastructure debt. But these assets link borrowers to new forms of risks. Climate change, in particular, poses an increasing danger for cities, be it the threat of increased hurricanes or typhoons, or the consequences of diminishing water availability.

In addition, several municipal borrowers have been targeted by hackers, which have managed to lock down their computer systems with ransomware. One such municipality, Lake City in Florida, had to pay a $460,000 ransom, while cities like Atlanta, Dallas and Baltimore have suffered similar intrusions.

RISING RISKS

These are unanticipated risks and they provide a new cost for the companies, be it in the form of the lost capacity, the ransoms they are forced to pay, or spiralling insurance costs to counterbalance such dangers.

These sort of dangers are likely to rise. Climate change only looks set to worsen, this despite the Paris Climate Agreement which set carbon emission reduction efforts to minimise a global temperature rise to 1.5 degrees Centigrade. As things stand, a rise of 3 degrees or more appears more likely.

As temperatures rise, so the severity of its effects will exacerbate traditional weather, fire and water scarcity issues – and force city governments to spend more to offset this or repair the damage. The swathes of burned land and destroyed towns due to Australia’s huge bushfires offer just one example of this.

In order to manage such risks, vulnerable and cash-strapped administrations will either have to take their chances – raising their vulnerability to a catastrophic event – or they will need to spend money to offset these risks. That will require them to raise more funds by issuing more bonds, which could reduce their value due to increased supply. The costs of servicing extra debt will also affect the money these cities have available, likely reducing what they have to spend on services. 

Meanwhile, municipalities that suffer the effects of a flash flood, severe hurricane or wildfire will see similar havoc wreaked on their economic activity, tax revenues, along with spiralling repair costs – and strain placed on timely bond repayments.

And that’s before unscrupulous hackers lock down all of their civil service records until they get a hefty pay-off.

Despite these concerns, relatively few institutional investors have spent time considering these extra costs of investing into municipal debt. That is going to have to change if investors aren’t to experience unforeseen falls in bond prices or even forced restructurings, courtesy of these new risks.

At the very least they should begin to demand more information about what municipal borrowers are doing to insulate themselves or prepare for increased storm patterns, less water, or the danger of unscrupulous digital hostage-takers.

As the old adage goes, failing to prepare is preparing to fail. But the price of preparation is likely to be slightly bigger yields – and risks of default.