Dirt-Bond Sales Near ’07 Peak Belie IRS Tax Ruling: Muni Credit

Demand for $6 billion of bonds sold to finance Florida housing developments shows no signs of waning even after the Internal Revenue Service said debt issued for a project of billionaire H. Gary Morse isn’t tax-exempt.

A Florida land-backed bond sale last week by Verona Walk Community Development District brought issuance of such debt this year to $323 million, close to the highest since 2007, data compiled by Bloomberg show. In May, the IRS alerted Morse that bonds sold to finance a district he created weren’t tax-free, a decision with potential implications for hundreds of similar entities.

Land-backed debt, dubbed dirt bonds, is the riskiest municipal segment, accounting for almost half of default filings where investors didn’t get paid, according to Concord, Massachusetts-based Municipal Market Advisors. Still, buyers are drawn by the extra yield. Wells Capital Management and Nuveen Asset Management plan to keep their bonds from Morse’s project while continuing to buy debt of certain districts.

“There’s a yield premium in the market for this type of debt that makes them competitive,” said John Miller at Nuveen, who oversees $95 billion of local debt in Chicago. “That tends to limit the amount by which the bonds would fall.”

Pace Prevails

Investors are seeking lower-rated local debt for the higher relative yields as the Federal Reserve holds its benchmark overnight rate near zero to spur the economy. Munis one to three levels above junk, encompassing the debt from Morse’s project, have earned 1.5 percent in 2013, compared with a loss of 0.4 percent on top-rated munis, Barclays Plc data show.

The IRS ruling related to $426 million of bonds sold by Village Center Community Development District, a Morse residential project in central Florida.

Perry Israel, the Sacramento-based attorney for the district, said June 7 that its board hasn’t decided whether to appeal the IRS decision.

Morse is the developer of The Villages, one of the world’s largest retirement communities, located on 33 square miles (85 square kilometers) in central Florida. Through his fully owned Holding Company of The Villages, Morse has built and sold more than 44,400 homes since 1983.

Different Beast

Village Center bonds rated three steps above junk and maturing in November 2032 traded last week with an average yield spread of about 2.2 percentage points, the lowest in five weeks, data compiled by Bloomberg show.

The project “is a different type of entity than a number of the other ones that we’ve seen or currently hold,” said Dennis Derby, who helps manage about $34 billion of munis, including $5 million of Village Center bonds, at Wells Capital in Menomonee Falls, Wisconsin.

Verona Walk issued $7 million of revenue bonds to refinance debt sold to build part of a 760-acre development near Naples on the Gulf Coast, bond documents show. Standard & Poor’s rated the deal A, the sixth-highest level. Bonds maturing in May 2035 yielded 4.48 percent, or about 1.4 percentage points above top-rated munis, Bloomberg data show.

The bonds are repaid from assessments on 935 residential units, of which only about 75 are undeveloped, Michael Rosen, Verona Walk’s district manager, said in an interview.

Audit Scenario

“It’s a fairly well-occupied development, and therefore there’s not a lot of risk for the bondholders,” he said.

Borrowing documents warned of a potential review of its tax-exempt debt and Florida dirt bonds in general given the latest IRS ruling.

If the IRS were to audit the Verona Walk bonds and determine that they aren’t tax-exempt, such a decision “may adversely impact any secondary market” for the securities and their price, the documents say.

The IRS determined that the Village Center bonds aren’t tax-exempt because the entity isn’t a political arm of the state, according to an IRS memo dated May 30. Since its creation in 1992, the district has been issuing debt with approval from a board of supervisors controlled by the developer, according to the IRS memo.

The agency said state law intends for the development districts to be turned over to residents who vote in board members at a general election. Yet the developer has owned sufficient land to appoint the board even though the district has existed for over 20 years, according to the memo.

Verona Walk’s documents indicate that four of its five board members are qualified electors, or residents of the district, who were voted in or appointed.

Research Requirement

Derby and Miller said buying Florida dirt bonds will require additional research into whether board members were elected by residents or handpicked by the developer.

“The results of this case, both what’s happened in the past and how it unfolds in the future, is going to add to our research criteria and our research process,” said Miller, whose firm holds $10 million of Village Center bonds.

An improving Florida housing market helps make the development bonds attractive, Miller said.

The April median sale price for a single-family Florida home was $165,000, the highest since at least January 2009, according to Florida Realtors, a profession trade association.

“Characteristics are improving generally in this market,” Miller said. “The reliability of repayment is going up.”

In the municipal market this week, New York City Transitional Finance Authority leads issuers offering debt with yields close to the highest since March 2012.

At 2.19 percent, yields on benchmark 10-year munis have exceeded the interest rate on similar-maturity Treasuries for seven straight trading days, the longest stretch in more than a month.

The ratio of the yields, a gauge of relative value, is about 101 percent. The higher the percentage, the cheaper munis are compared with Treasuries.

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