Issuers of U.S. high yield municipal bonds are taking advantage of yield-starved investors, weakening standard provisions that shield buyers from the risks that a project, an issuer or the economy will go sour.
Debt service reserve funds, which are used to repay bondholders if a project doesn't produce enough cash, made the high-yield sector of the $3.7 trillion tax-free municipal bond market a safer place for retail and institutional investors.
But this safeguard is slowly disappearing. July and August could see this trend accelerate.
Forecasts for net negative issuance - when the supply of new bonds falls below the amount of bonds redeemed or refunded - and record demand for relatively safe and profitable investments - are helping these deals find homes - even without those defenses. But some major institutional buyers are wary.
"We're getting into the place where it's an issuer's market, the covenants, the types of reserves, the collateral provided, do not make the structures as attractive," as they previously were, said Michael Walls, a portfolio manager with the Ivy Funds in Overland Park, Kansas.
As the U.S. economy slows and Europe struggles to regain fiscal stability, safety-seeking investors have driven Treasury yields to historic lows. Bolder municipal investors are gaining fatter yields by buying debt issued by struggling issuers, such as California, and wading into the high-yield sector.
The Barclays high-yield municipal bond index had a total return of 9.61 percent for the year-to-date period ending June 21 versus 3.60 percent for the broader municipal bond market. The Treasury index only returned 1.69 percent. All maturities in the indexes are longer than one year.
A prominent example of an issue becoming more risky is the $774 million of prepaid gas bonds that Goldman Sachs (GS.N) is underwriting for Alabama's Black Belt Energy Gas District. The deal was postponed last week; a Goldman spokesman had no immediate comment on when the sale might be rescheduled but there is market speculation it will be soon.
Prepaid gas bonds provide local utilities with a steady supply of natural gas at a pre-determined price, protecting them from volatile energy prices. The banks that underwrite and structure the deals gain access to funds at tax-free yields, while their commodities units provide the gas supply.
Until recently, a credit rating downgrade below investment grade for the bank standing behind the deal typically required it to deliver hundreds of millions of dollars in cash, cash equivalents or a letter of credit.
But the new Black Belt Energy bonds - along with the only prepaid gas bond issued so far in 2012 -- a $613 million issue by the Central Plains Energy Project, which also was underwritten by Goldman - have no credit rating trigger.
On June 21, Goldman Sachs was downgraded two notches to A3 from A1 - still comfortably in the investment grade zone - by Moody's Investors Service.
On Friday, the vulnerabilities of the prepaid gas bond sector were highlighted when Moody's Investors Service cut ratings on 24 issues worth about $19 billion. The downgrades were a knock-on effect from the credit agency's cutting the ratings of 15 banks on Thursday.
JULY AND AUGUST, TWO MONTHS AT RISK
"The change that I have seen in the transactions, generally, as of late, especially in the Central Plains and Black Belt deals, is that a lot of risk is now being backstopped by the gas supplier or the investment bank, in a secondary capacity through structures like a receivable purchase agreement or a custodial agreement," said Bhala Mehendale, a director at Fitch Ratings.
Last January, investors in a $1.8 billion deal issued by the Tennessee Energy Acquisition Corp in 2006 voted in favor of a proposal from Goldman to scrap the credit rating trigger.
Lower-rated nonprofit hospital bonds are other examples of deals that are offering investors fewer protections. A $60 million sale by the Maryland Health and Higher Education Facilities Authority, Carroll Hospital Center Issue, on May 2 had no debt service reserve fund, according to offering documents.
Those reserve funds, an important safety feature to some investors, were common when demand for high-yield municipal bonds was lower.
James LeBuhn, a Fitch Ratings analyst, said there has been a shift from the first half of 2011, when municipal investors were still rattled by Wall Street analyst Meredith Whitney's prediction that local governments would default on hundreds of billions of debt. The subsequent rebound in demand has allowed issuers to weaken protections previously seen in bond covenants.
On Thursday, a $182 million offering by the Phoenix Industrial Development Authority for Rowan University had no debt service reserve fund, according to the preliminary documents.
A $46 million sale by Florida's Higher Education Facilities Revenue and Refunding Bonds, a Nova Southeastern University project, in April also lacked the protections that investors used to demand, Walls said.
July and August might be a particularly vulnerable time for investors because that is when a net negative supply is expected to develop.
In July, redemptions could hit $42 billion, easily surpassing the $26 billion sales calendar, according to a research report by RBC Capital Markets. Likewise, August's redemptions could total $34 billion versus $27 billion of supply.
"That would be an opportunity when you could have 'covenant-light' deals," commented Steve Czepiel, lead portfolio manager at Delaware Investments in Philadelphia.
(Reporting By Joan Gralla; Additional reporting by Caryn Trokie; Editing by M.D. Golan)