Chasing Yields, Muni Buyers Sign Away Safeguards Against Default

  • Hunt for yield and lack of supply gives upper hand to issuers
  • Borrowers are forgoing mortgage pledges and reserve funds

When Mount St. Mary’s University, a small Catholic college, borrowed money a decade ago to build and renovate dorms at its rural Maryland campus, it pledged a 179-bed residence hall as collateral, leaving investors with an asset they could seize if it defaulted.

In December, it refinanced the debt without extending bondholders that security. Lenders didn’t mind, placing nine to 12 times as many orders for $56.6 million of junk-rated bonds than were available, according to William Davies, the university’s chief financial officer.

The demand for higher-yielding debt during the decade-long era of low interest rates has allowed hospitals, schools and other borrowers in the $3.8 trillion municipal-bond market to jettison some of the protections they previously provided to investors. Even now, amid growing speculation about rising interest rates, a steady flood of cash has pushed risk premiums to their lowest level since the financial crisis.

High-yield municipal-bond funds have drawn in $23 billion in the last four years, about a quarter of inflows into state and local bond funds over that time, according to Lipper U.S. Fund Flows data. That has helped drive spreads over top-rated bonds to 2.92 percentage points by Feb. 12, down by about two-percentage points from two years ago.

“Borrowers have had very strong leverage over lenders for three years," said Jim Murphy, who oversees T. Rowe Price Group Inc.’s $5.5 billion Tax-Free High Yield Fund.

In addition to forgoing mortgage pledges, borrowers are selling bonds without reserve funds they can tap if they don’t have enough cash to service debt. Early warning mechanisms, such as rate covenants, which require borrowers to charge enough fees to pay debt service, are often weaker and remedies can be more limited than they had been, according to Municipal Market Analytics.

That will likely cause an increase in defaults -- which are extremely rare -- if the economy weakens, said Matt Fabian, a partner at MMA. 

“The more bonds done without a reserve fund or without a mortgage or with minimal coverage, the more likely they are to transition directly to default from under stress," he said.

Sales by the riskiest segments of the municipal market, which includes hospitals, charter schools and retirement facilities, has risen to 16 percent of issuance from 11 percent in 2014, according to the firm. Before the financial crisis, in 2007, such sectors made up about a quarter of municipal bond sales, according to MMA.

The weakening of bondholder protections are most obvious in health-care and higher education, sectors that “in normal times" tend to have the most standardized contract terms, NewOak Capital Managing Director Triet Nguyen wrote in a Feb. 16 report.

“Those sectors also happen to include some major hospital systems and universities, well-recognized credits that can flex their muscles in the marketplace," he said.

In contrast, investors are demanding stronger security on distressed tax-backed bond issues by Chicago and Chicago Public Schools, resulting in some debt service payments being legally segregated from their operations. Both the city and its schools face growing financial pressure from their underfunded pension systems.

Last June’s $1.1 billion sale of unrated municipal bonds to finance American Dream, the long-stalled shopping and entertainment center in New Jersey’s Meadowlands, about 10 miles (16 kilometers) west of Manhattan, marked a “new low” in investor protection, Nguyen wrote. Failure to pay debt service on an $800 million tranche of bonds backed by payments in lieu of property taxes isn’t even considered an "event of default," he wrote.

In August, SoutheastHealth, a BBB- rated health-care network in southeast Missouri, issued about $92 million bonds without a debt-service reserve, allowing it to spend more of the deal’s proceeds on operations, said Steven Haas, the system’s chief financial officer. Investors placed $900 million in orders for the bonds, he said.

“We had no problem selling it, so why sell it with a debt service reserve fund if you don’t need to?" Haas said.

Mount St. Mary’s University, in Emmitsburg, Maryland, near the Pennsylvania border, didn’t pledge a mortgage on one of the dorms to secure its bond issue because it “really wasn’t providing any additional comfort for bondholders," said Davies, the CFO. 

Instead, if the college can’t meet certain financial metrics, it has to hire a consultant to improve operations, Davies said.

Investors may get more leverage if interest rates rise and money flows out of high-yield funds -- although that may be counterbalanced by diminished municipal-bond supply resulting from the tax overhaul enacted last year that restricted the ability of borrowers to refinance debt, T. Rowe Price’s Murphy said.

“These periods tend to move in cycles," he said.

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