California paper wobbled in secondary amid historic wildfires

The municipal bond market’s initial negative reaction to this month’s devastating Southern California wildfires has eased, and most market watchers have faith in the ability of the Los Angeles region to rise from the ashes.

Spreads widened last week on the Los Angeles Department of Water and Power amid downgrades and downward outlook revisions — the most recent on Wednesday — but have tightened up a bit, according to buyside analysts.

“Based on trade data, the sell-off in Los Angeles/California-related credits has subsided since last Thursday, with spreads generally compressing over the past two sessions,” J.P. Morgan strategists said Thursday.

California paper has cheapened up nicely for investors with cash, according to Municipal Market Analytics’ Weekly Outlook published Tuesday.

Buyside analysts have been closely tracking LADWP and larger Los Angeles city and county credits, but say more risk may reside in smaller issuers.

Among them is the Altadena Library District, serving the community devastated by the Eaton Fire, which destroyed thousands of structures.

In 2020, it sold $21.1 million of bonds backed by a special property tax in its Community Facilities District No. 2020-1.

The district “anticipates that the majority of the structures damaged or destroyed are within the boundaries of the Community Facilities District,” it said in a Jan. 17 notice posted on the Municipal Securities Rulemaking Board’s EMMA bond disclosure website. Its two libraries were spared.

MMA described it in its Wednesday Default Trends report as “the first municipal borrower affected by the L.A. wildfires to disclose a related credit issue.”

S&P on Jan. 16 put its underlying AA-minus rating for the bonds on CreditWatch with negative implications.

“We believe that the fire and reports of widespread damage introduce near-term risk to the CFD’s special tax base,” S&P said.

“This particular bond series is also wrapped by Assured Guaranty, so the potential for non-payment on bondholders is minimal,” MMA wrote.

Moody’s Ratings was the latest to act on Los Angeles credits Wednesday, lowering to negative from stable the outlooks on LADWP water and electric revenue bonds, city of Los Angeles GO and enterprise bonds, Southern California Public Power Authority projects tied to LADWP, and Utah’s Intermountain Power Authority, which is also closely linked to LADWP.

Moody’s affirmed all the ratings, which stand at Aa2 for the LADWP revenue bonds and Los Angeles GOs.

Heavily populated neighborhoods were devastated when wildfires quickly spiraled out of control after 80- to 100-mile Santa Ana winds struck a tinder-dry region Jan. 7.

The two largest fires — Palisades and Eaton — are still burning and there is some uncertainty around assumptions that have protected ratings during previous natural disasters.

The Palisades fire was 72% contained as of Thursday, and the Eaton fire 95% contained, but another fire, the Hughes fire, sparked in northwestern Los Angeles County unincorporated community of Castaic had burned more than 10,000 acres as of Thursday.

“If you can tolerate the volatility than it makes sense now” to buy Los Angeles paper while it has been cheapened from the fires, MMA’s Lisa Washburn said.

“It doesn’t mean there won’t be stress and uncertainty around these credits,” she said. “But they are such large credits, with a large geographic area and tax base. What has been affected is a relatively small portion of Los Angeles County in terms of the tax base, and they should be able to recover from that.”

The state, city and county governments will have to put in more money for the recovery effort and to rebuild, Washburn said.

“That should take a while, but the state of California is in a relatively good position,” she said, noting it has rainy day accounts and budget stabilization mechanisms.

Los Angeles County, with 10 million residents, is the nation’s most populous county, she said, and its core metropolitan area has a $1.3 trillion economy.

“It is almost imperative the state does what it needs to help the area recover,” Washburn said, adding that the state has taken steps to help, including assuring the Los Angeles Unified School District, Pasadena USD and other school districts they will continue to receive funding at prior levels, even if enrollment declines occur as a result of the fires.

“With that said, it’s horribly devastating,” Washburn said. “It may harm the tax base, but not to the extent investors would be worrying over debt repayment.”

“We have made some adjustments in context to California bonds,” said Patrick Smith, ICE senior director and head of municipal evaluations. “The most affected issuer has been DWP. Its spreads have been significantly wider, but it appears things have stabilized.”

Spreads on SoCal Power and the Intermountain Power Agency in Utah have also widened, Smith said. IPA was trading 50 basis points wider, he said.

When S&P downgraded LADWP by two notches on Jan. 15, taking its power system revenue bonds to A from AA-minus and the water system revenue bonds to AA-minus from AA-plus, “the market reaction was fierce,” said Pat Luby, head of municipal strategy at CreditSights.

Last week, Luby said, the LADWP water and sewer bonds in the ICE Muni Index “posted a negative total return of -1.69% and the power bonds did worse, posting a total return of -2.11%.”

The spread for 10-year California GOs “cheapened last week to +2 as of Friday, from -6 as of Jan. 10, but the spread for the 10-year BVAL DWP power bond benchmark closed Friday at +45, 59 basis points wider since the prior Friday,” Luby said.

It’s possible spreads for LADWP and other Los Angeles-area credits continue to widen further due both to the “massive uncertainty” about costs and liability for the Palisades and Eaton Fires, which are not yet fully contained, Smith said.

“We did see Los Angeles Unified School District’s bonds trade wider, but not to the same extent,” Smith said. “Some California Public Works (state revenue) bonds were trading wider, but not to the extent that LADWP was.”

LADWP’s spreads have likely stabilized, because its service area “covers a lot of ground, and they have a lot of customers” and there is some crossover and protection to LADWP’s credit from its connection to the Los Angeles city government, Smith said.

“LADWP bonds provide at least 30 basis points above AAA following the S&P cut: a solid add for a credit with only a moderate long-term downside away from the new headlines, assuming what should be very likely state support to afford fire-related costs,” MMA wrote in its Weekly Outlook.

The larger question around potential liability for LADWP from the fires is a bigger question that would come into play later, Smith said. The as yet unanswered question of liability would be whether LADWP would then have to levy higher bills on ratepayers, Smith said.

“Coupled with the potential for added selling pressure from investors, it is possible that further spread changes could overstate the decline in the margin of safety for bond holders,” Luby said. “Until there is more information about the scale of destruction and the financial impact, it is difficult to offer a firm opinion about the newly adjusted spreads for the LADWP bonds, but we do expect that the much wider spreads will attract speculative buyers this week.”

As of Jan. 16, property information and data provider CoreLogic estimated insured residential and commercial losses of between $35 and $45 million for the Eaton and Palisades fires, with total economic costs much higher.

The larger takeaway is that “the fires and the rating agency responses should be leading investors to think a bit differently about the climate risk their portfolios are carrying,” said Matt Fabian, MMA partner.

“Looking more broadly at public finance credits, there could be more emphasis on preparedness and adaptation to climate risk,” Washburn said. The level of devastation, which was unimaginable before, she said, will result in ratings agencies and investors asking more pointed questions about preparation ahead of the next major climate event.

The 2018 Camp fire in northern California that leveled the town of Paradise still tops the California Department of Forestry and Fire Protection’s lists of most destructive fires, with 18,804 structures destroyed, and the most deadly, with 85 dead.

The Easton and Palisade fires have destroyed a combined 16,000-plus structures and killed 28, according to preliminary CAL FIRE data.

Washburn notes the difference with the Los Angeles-area wildfires is that they have caused the destruction in heavily-populated urban areas with higher property values.

Jessica Lerner contributed to this story.