By Gunjan Banerji and Heather Gillers
Investors are flocking to riskier corners of the traditionally
safe municipal bond market in a search for yield.
They are buying hundreds of millions of dollars of debt issues
from unrated and below-investment-grade borrowers such as energy
projects and upstart charter schools.
It is a shift within a part of the bond market commonly
considered almost as safe as Treasurys. Municipal-bond payments are
often backed by taxes or revenue from essential services. The bonds
are known for low default rates and prized by investors for stable
returns and interest payments that are typically tax-free.
Yet the return of superlow rates this year has driven investors
to seek out less traditional versions of muni bonds that offer
higher returns. On Wednesday, the Federal Reserve cut rates by a
quarter-percentage point for the second time in recent months, to a
range between 1.75% and 2%.
The sale of riskier new bonds, combined with the deterioration
of some existing debt, has increased the amount of junk-rated and
unrated debt outstanding by 20% since 2012, according to Municipal
Market Analytics and the Federal Reserve.
It remains a small slice, about 9%, of the $4 trillion muni-bond
market, according to MMA and Fed data. But high-yield municipal
funds have attracted more money in the year to August than in any
other year on record, drawing $14 billion, according to Refinitiv
data going back to 1992.
The appetite for muni debt includes less traditional offerings
in which governments extend their tax-exempt borrowing power to
efforts to build or renovate hospitals, dormitories, energy plants,
and even malls and stadiums.
For example, investors recently welcomed the largest unrated
charter school deal ever, according to Equitable Facilities Fund,
which tracks the market. Overall issuance in that sector has risen
roughly fourfold over the past decade.
Bonds such as these aren't backed by a promise to raise taxes if
necessary, as is often the case with cities and states seeking
funds. As a result, they typically offer additional yield to
compensate for that risk -- income that has proved tantalizing for
investors after years of rock-bottom rates.
"We are seeing more speculative projects find their way into
municipal bond financings today than we have over the last handful
of years," said Robert Amodeo, head of municipals at Western Asset
Management.
Already, though, there are some worrisome signs. Reports of
problems filed by borrowers -- ranging from outright defaults to
tapping cash reserves to make payments -- so far this year have
reached the highest level since 2015, according to MMA. There were
101 such issues through August, compared with a five-year average
of 90, MMA data show.
While overall municipal defaults remain rare, the probability of
a speculative-grade muni bond defaulting within 10 years has ticked
up. It rose to 12% over the past decade, compared with 4% for the
period from 1970 to 2008, according to data from Moody's Corp. on
bonds rated by that firm.
Recently issued debt -- both speculative and investment-grade --
also is going sour more quickly. Among bonds that have reported
impairments since 2017, some 40% encountered that trouble within
three years of being issued, MMA data shows. In the previous seven
years, an average of 24% of impairments affected debt issued that
recently.
"God help us if there's a recession," said Tom Doe, president of
MMA.
Some investment-grade rated bonds are also deteriorating
quickly.
Last year, ratings firm S&P Global Inc. downgraded to junk
roughly $250 million in bonds issued by nonprofit Provident
Oklahoma Education Resources Inc. to build student housing and a
parking garage on the University of Oklahoma campus in Norman,
Okla. The project hadn't yet been completed, but it had become
clear not enough students wanted to live there, weighing on the
nonprofit's revenues, S&P said in a report.
This August, after the project had been completed, the company
didn't have enough money on hand to make a bond payment and had to
draw on its reserves, according to a disclosure on Electronic
Municipal Market Access, a public bond database.
S&P further downgraded the debt eight notches and said
revenue and reserves may not cover debt payments next year.
Steve Hicks, president of Provident Oklahoma, has blamed the
university."We have never had a university fail to honor their
commitments to support their projects to the degree that OU has on
this project," he said, adding that the university didn't renew a
lease on commercial space or a license on parking, as Provident had
anticipated.
A spokeswoman for the university said it "met all of its legal
obligations" and that the university "has a responsibility to act
in a fiscally responsible manner and in the best interests of the
students and citizens of Oklahoma."
For now though, investors are focused on yield, not risk.
"We have a food fight going on by investors," said J.R. Rieger,
author of the Rieger Report, a bond market newsletter. "If there
was a fiscally weaker municipality that needed to raise funds, this
is the time to do it."
In 2017, charter school International Leadership of Texas fell
afoul of its required debt-service coverage ratio, a measure of how
much cash the school has on hand to make bond payments.
Around that time, the fast-growing school system ended up laying
off about 60 staff members to save millions in payroll annually to
meet its required ratio again.
But investors snapped up a $357 million offering from the school
system last year, the largest unrated charter school deal on
record, according to the Equitable Facilities Fund, which helps
charter schools secure financing.
It is "one of the reasons that we were able to grow," Eddie
Conger, the school's superintendent, said of the bond issue. He
said the school has made adjustments since 2017 and added that he
is contemplating a return to the bond market next year.
The willingness of investors to look past prior problems is also
allowing some issues to add debt yet cut borrowing costs. Palomar
Health, a hospital system in Southern California has struggled with
union contract negotiations and low levels of cash in the past,
according to a Moody's report.
But it was able to borrow an additional $60 million while
refinancing debt in 2017. And its interest costs fell by half a
million dollars a year, said Carlos Bohorquez, the hospital's chief
financial officer.
"It was a win-win," said Mr. Bohorquez.
Write to Gunjan Banerji at Gunjan.Banerji@wsj.com and Heather
Gillers at heather.gillers@wsj.com
(END) Dow Jones Newswires
September 21, 2019 10:05 ET (14:05 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.