MARKET UPDATE: CALIFORNIA WILDFIRES

Highlights

• We believe strong credit metrics from the State and Los Angeles County coming into this event will help them weather the enormous hit. Still, rating agency downgrades are likely until a clearer picture arises.

• While loss estimates are expected to be significant, and the change of administration will make the near-term politicking more of an issue, we do expect Federal, state, and insurance proceeds to support the rebuilding effort.

• Despite the guarantee of Federal money, the increased debt load from certain issuers, including the state, to cover ongoing costs could create wider credit spreads and a more permanent repricing of risk.

• Municipal Utility issuers may face a new rating and market environment ahead.

• We will continue to be highly selective in stand-alone facilities and any extraordinary redemption provisions (ERPs) they may carry.

• Large, consistent issuers create broadly held positions across many different investment products, which could lead to short-term liquidity dislocations.

• APA is not concerned with impairment or default risk at this time. 

The scenes of destruction across Los Angeles County are truly heartbreaking. Our thoughts are with our clients, friends, and partners impacted by the fires. Following the devastation caused by last fall’s hurricanes in the Southeast, we continue to admire the resilience of the human spirit. As managers of municipal credit, we remain committed to protecting our clients from the risks associated with weather-related events.

Historically, the municipal market has also proven resilient to natural disasters, with minimal lasting impact on municipal debt. Federal funding has typically stepped in to cover reconstruction and recovery costs. However, the scale of these fires, combined with the associated financial implications for reconstruction and debt servicing, has left market participants with a sense that this time may be different.

At APA, wildfire risk has always been a critical component of our credit analysis, particularly in California. This approach allows us to assign bottom-up valuations to individual issuers across the state. The increasing frequency of climate-related events has made ongoing surveillance of metrics and market liquidity even more essential. As our clients know, we have historically focused on essential service revenue bonds and well-secured unlimited general obligation pledges, while avoiding stand-alone facilities that are more vulnerable to climate devastation. Just as hurricanes are a fact of life in states like Florida and Texas, wildfires are becoming an entrenched reality in California and other western states. What sets the current fires apart is the volume of debt outstanding in the affected areas and the broader market implications of this exposure.

The municipal issuer earning the most headlines currently is the Los Angeles Department of Water and Power (LA DWP), including a swift reaction by S&P to downgrade the power debt two notches from AA- to A, with a still-negative watch. LA DWP consists of the largest municipal power utility and the second largest water utility system in the country. While the water system debt has yet to be impacted by the rating agencies (at the time of writing), it has also seen an immediate adjustment to market pricing. APA has highlighted the credit strength of this essential service provider many times, including days cash on hand, solid coverage levels, and strong rate-setting ability. The market is not pricing in impairment; however, the risk here lies in the potential liability through inverse condemnation and the large amount of future debt issuance that may need to be raised to cover those costs. There are still many uncertainties regarding how the waters system credit will be viewed vs. the power system or if they will be all viewed together under the parent system. The market is not waiting for those answers, driving yields higher across the curve, widening credit spreads by roughly 70-80bps, with many benchmark maturities finding two-way trading at a spread of 50-60bps above the stated AAA scale. Compare this to the negative spread DWPs were trading prior to the fires.  

It is not unusual for a single issuer to take the brunt of headlines after a destructive event. The debt outstanding of DWP and other Los Angeles area credits is where the broader market unease still lies. Depending on how broad the potential impacts are, roughly $65 – 75bln of outstanding municipal debt is susceptible to increased costs (including a now delayed-indefinitely LA DWP financing that was originally due to price on January 14 - 15). With that type of size and index eligibility, these are common names in every municipal bond mutual fund, ETF and California SMA across institutional and professional retail holders, alike. While trading thus far has been in a very reassuring, orderly fashion, with solid two-way markets, we are closely monitoring flows into and out of holders of the debt. 

At the time of writing, most schools in the region, including the LA Unified School District, are open and operational. However, the indefinite delay of a Santa Monica-Malibu School bond deal highlights the potential for smaller districts to face wider credit spreads. We believe Proposition 98 provides strong credit security for California school districts, but the long-term impact on property tax collections, particularly if home values and land prices are significantly affected, is a concern we are monitoring closely.

The insurance market is certainly a topic of conversation. While we won’t get into the insurers that have left the region, we are closely monitoring the recovery on homes and whether it will be attractive enough for many residents to rebuild.  The long-term impact to the State revolves around The California FAIR (Fair Access to Insurance Requirements) plan, the insurer of last resort, and the ultimate exposure they will take on. The likely billions in claims will far exceed the few hundred million the insurer had on hand before the fires. We expect to see larger debt issuance over the coming years to potentially cover more uninsurable areas.

For our California clients with exposure to names being repriced, there will likely be a hit to market valuations in January. The good news for the market moving forward is that while we do expect to see increased debt load for all issuers affected, the abrupt Band-Aid being ripped off, so to speak, will make the wider clearing levels more attractive and allow us to swap positions for now, higher-yielding holdings.  Additionally, we welcome the wider trading credits as a potential for new entry for investors. For years, the demand for tax-free income in California has outpaced concerns about credit risk. This market shift may finally lead to more appropriate pricing for issuers in disaster-prone areas.

APA will continue to monitor this ongoing situation closely. If you have any questions regarding specific issuers and/or the market activity, please do not hesitate to reach out. ContactUs@APABonds.com. (404) 261-1333.

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This material is not financial advice or an offer to sell any product. APA is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about the advisor including its investment strategies and objectives can be obtained by visiting www.assetpreservationadvisors.com. A list of composite descriptions is available upon request.

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