(Bloomberg Markets) – When I hear complaints about some of the riskiest municipal bond trades in the market today, I think back to my “map talk” in 1999.
I was the luncheon speaker at the National Federation of Municipal Analysts’ Advanced Seminar on High Yield Bonds in Santa Monica, California. Without any props or projections, I took the room full of bankers, analysts and investors on a virtual tour of many of the interesting, even fabulous deals I had written about. Grant Municipal Bond Observer over the previous few years.
We visited a de-inker (which recycles old newspapers into new rolls of paper) in Massachusetts and a vintage 1938 aquarium in Florida. We stopped in Alabama to see VisionLand, a water theme park showcasing the history of Birmingham’s steel foundry, then detoured to a nearby dead poultry recycler (backers used the term “broiler mortality”) in chicken feed. Then we went to a museum, the Great Platte River Road Memorial Archway, which funders expected “virtually every resident of Nebraska [to] possibly visit during his lifetime. We saw a series of golf course developments in the California desert. And much more.
All of these projects, a dozen in total, were built by municipal bonds. Almost all had been sold in denominations of $5,000 to anyone willing to take the risk. And all had or were soon to fail.
Vintage-aquarium bonds were initially offered in minimum denominations of $100,000, but the underwriter could not sell them all. So they restructured to sell in the usual $5,000 amounts, opening the deal, which carried coupons of 8.5%, to anyone and everyone, including unsuspecting mom and pop investors. Several members of the original financing team, including the bond attorney, the city attorney and the trustee, resigned in disgust.
After my interview, I remember dragging two analysts out the door and hearing one of them say, “That was pretty funny,” and his companion say, “Yeah, until it comes to your agreement. It made my day.
The underlying messages of my speech on the map were:
Aren’t these municipal bonds crazy?
And: You sold most of them to retail investors.
And: Are you crazy?
Of course, the 1990s were a particularly turbulent time for public finances, when it looked like retail investors would buy almost anything in the municipal market. One of my treasured relics from that time is a banker’s presentation from that same conference that lays out the details of a number of proposed deals, including the Las Vegas Monorail (funded and bankrupt) and a theme park called the Wonderful World of Oz, to be built, of course, in Kansas (unfunded).
At the time, I thought it must represent some sort of peak. In 2000, two high-yield municipal bond funds from Heartland Advisors had to depreciate their net asset values because a large number of the bonds they held were in default. Of the 54 bonds in a fund, 27 ran into some sort of distress, which has yet to be something of a municipal market record. I thought it would surely ruin people’s appetite for risk. But no, this market was just beginning to pick up speed and would not reach its peak until after the 2008 financial crisis, when investors from all credit backgrounds quickly became much more cautious.
It wasn’t until 2017 that, while preparing for the daily Municipal Market briefing with my colleague Amanda Albright, I thought, “Wow, junk food is back. One of Amanda’s stories, literally about a waste recycler, was titled “Junk-to-Jet-Fuel Company Tapping Muni Market With Unrated Deal”. It was not the only transaction of this type. There were a number of visionaries who tapped into the muni market for projects designed to take a form of waste and turn it into biofuel that year. In January 2018, I decided to give another virtual card talk, this time at the Bond Attorneys Winter Workshop in Palm Beach, Florida.
I took the attorneys who attended the speech on a virtual tour of some of the most notable projects that had recently issued municipal bonds: New Jersey’s American Dream Mall; a private aircraft terminal in Westchester County, NY; Elvis Presley’s home, Graceland, in Memphis; and a new high-speed train in Florida. Not to mention two biofuel refineries in Nevada and Oregon. In total we made 17 stops. Issuance of so-called “story” bonds – sales of bonds that have a unique story behind the project – had really picked up. This time almost all were sold in minimum denominations of $100,000, $250,000 or $500,000, and generally only to qualified institutional buyers as defined by SEC Rule 144A. It shows how muni junk has changed for the better. Even just using high minimum denominations such as $100,000 reduces the risk of garbage ending up in the accounts of unsophisticated investors.
When I came back the following year, I said to the lawyers, “Do you remember the tour last year? Well, I could easily give an expanded one this year! And that rhythm continued, more or less unabated. Yes, the Federal Reserve is raising interest rates, and that has choked off some transaction flows, especially repayments, but there’s always a new recycler or a private aircraft hangar operator or a hotel developer from convention center wishing to propose a new contract. The warnings have started to get serious: In September, Matt Fabian and Lisa Washburn of Municipal Market Analytics called for vigilance as challenges mount in key sectors including hospitals, higher education and retirement homes . That same month, the Securities and Exchange Commission charged four municipal bond underwriters with failing to follow disclosure rules when selling the debt to investors.
Now, of course, “junk” and “municipal bonds” really shouldn’t be used in the same sentence. Municipal bonds mean security and preservation of capital and predictable income, and state and local governments pledge their taxing powers to the holders of their securities. Junk represents speculation, the new and the novel – and most likely financial oblivion.
Good old municipal bonds have a default rate of a fraction of 1%. In 2003, Fitch Ratings conducted a study showing that the default rate on muni junk was closer to 15%. I have not seen this study reproduced, and it remains a good criterion for me. Municipal Market Advisors, the independent research firm, recently reported that 0.37% of all municipal bonds outstanding, excluding those in Puerto Rico, are currently in default. If someone approaches you and says, “Now we’re selling munis to fund a theme park called the Wonderful World of Oz, Kansas,” your response should be, “You’re kidding me.” , not “Of course you are.”
Except “Of course you are” is usually the real answer, for decades now is and will continue to be. The reason: Junk munis are used to fund everything from charter schools, assisted living facilities and real estate developments to recycling plants and tourist attractions. Even if investors lose their taste for crazier bonds, they are unlikely to walk away from risk altogether, as it represents a return in a market where yields are typically slim.
There’s bric-a-brac, and then there’s bric-a-brac, and a lot depends on how you define it. Are they only non-investment grade rated offers? What about the unrated market? Many small, infrequent, ordinary municipal bond issuers come to market without a credit rating. I once calculated that their tax-funded offerings cost around an A-level. It’s not junk.
To me, the only way to define junk food is to count offerings sold in minimum denominations of $100,000 and above. They are generally unrated and are generally only sold to qualified buyers. This categorization may miss some speculative-grade offerings, but not many.
Much of the migration of junk food to this market of qualified minimum-value buyers is the result of regulatory reform. In the 1990s, after the collapse of Colorado’s housing market, the state required that the riskiest development bonds used to finance housing construction, which were then in default, be sold in these higher minimum denominations.
I could give you the alphabetical soup progression of this, with exemptions from the disclosure rules in rule 15c2-12 all the way to the codification of sophisticated municipal market professionals in rules D-15 and G-48 of the Board of Municipal securities regulations, but a little of that goes a long way. I like to think that self-preservation and maybe even a sense of decency have something to do with it. Remember that the MSRB is the industry’s self-regulatory body.
Because what happens when a speculative project fails? For an individual investor who might have three or four names in his portfolio, that’s a disaster. For a professional manager with 300 or 400 credits, that’s a footnote.
And this is another reason why the municipal flea market is flourishing: the growing professionalization of the municipal market. Beginning in 1981, the household sector became the largest holder of municipal securities, overtaking depository institutions, which had been the main players since 1965, according to Fed data on funds flows. It’s no wonder retail got stuck with trash in the 80s and 90s – retail investors were the big buyers of muni.
Mutual funds did not become a factor in municipalities until the mid-1980s (although they first appeared in Fed data in 1976). Today we have mutual funds, closed end funds, exchange traded funds and international buyers all looking for municipal bonds and all looking for yield. Not to mention hedge funds, private equity funds, personal trusts, and separately managed accounts. The number and variety of buyers has grown even as annual municipal sales have averaged about $350 billion over the past 10 years, and keep in mind that most of these buyers are investment grade, aimed at the individual retail market.
This growing number and diversity of sophisticated shoppers is why junk food lives on. And that’s why, in another decade or two or three, whoever is the municipal market columnist at that time, he will be able to give a speech on the map.
Mysak writes about the municipal debt market for Bloomberg News in New York. This column does not necessarily reflect the opinion of Bloomberg LP and its owners.