SAN FRANCISCO — The financial woes of some California local governments, epitomized by Stockton, have spooked some investors out of lease revenue bonds.
Aside from Stockton, which defaulted on lease revenue bonds as it launched a restructuring process that could lead to bankruptcy court, a slew of cities in the state have seen lease revenue bond ratings plummet in recent months.
The sometimes unexpected and multiple-notch ratings downgrades, along with the general economic malaise pervading local governments in the state, have increased investors’ concerns.
“We haven’t been buying many lease revenue bonds recently just because of the overall weakness within California,” said Alexander Anderson, a portfolio manager at Envision Capital Management in Los Angeles. “State and local governments are struggling all over the place. You want to buy debt that is higher on the totem poll.”
Lease revenue bonds are especially important to local governments in California because the threshold is so high to get approval for general obligation bonds.
According to the state constitution, counties, cities and towns must get approval from two-thirds of voters to issue GO bonds.
This has led many California municipalities over the years to sell lease revenue bonds to fund projects or acquire facilities. Typically, a local government will lease the property from an affiliated financing authority.
This can lead to riskier debt structures compared to local California GOs, which are secured by a dedicated, unlimited property-tax levy. Lease revenue bonds are often paid for out of the city’s general fund, which may come under strain in tough times.
“There are some people in the marketplace that have always been reluctant to buy lease revenue bonds,” said Bud Byrnes, chief executive officer of Los Angeles-based RH Investment Corp., a broker-dealer specializing in California municipal bonds. “Skepticism has increased recently because of the Stockton situation and with so many municipalities scrambling for revenue.”
Stockton stoked more skepticism because it skipped debt service payments on two lease revenue bond issues. The City Council voted in February to stop payments from its general fund towards three different bonds through June in an effort to shore up finances while it undergoes a mediation process designed to help the city restructure its finances outside of bankruptcy.
After the first bond default, the city found itself in court with bond trustee Wells Fargo, which sued the city at the behest of the insurer National Public Finance Guarantee for control of three city-owned parking garages that secured the bonds.
A judge in April ruled in favor of the bank’s request to appoint a receiver to oversee the garages.
Stockton faces another legal test after not making the May 1 payment for another set of lease revenue bonds used to acquire an office building that had been set to become the new City Hall.
Although the defaults may scare some investors, the swift and successful recourse by Wells Fargo on the garage bonds may also scare some municipalities.
“I think the favorable ruling for NPFG and bondholders in Stockton regarding the parking garages is an eye-opener for any municipality that is contemplating breaking leases,” said Stephen Candido, vice president and senior research analyst at Nuveen Asset Management in Chicago. “The bottom line for us is the essentiality of the underlying asset which should be factored into the price of the bonds.”
In a market where yield is hard to find and more municipalities are struggling, investors have been forced to dig deeper into what secures a lease revenue bond and how the asset stacks up in the local government’s priorities.
“You certainly have to take a much closer look at lease revenue bonds than in the past,” said Kenneth Naehu, fixed-income portfolio manager at Bel Air Investment Advisors in Los Angeles.
“The way that I often explain it is that today’s double-A bonds can be tomorrow’s triple-B bonds.”
One of the most recent examples of a so-called super-downgrade came last week when Fitch Ratings dropped $19 million of outstanding lease revenue bonds issued by El Monte, the 10th largest city in Los Angeles County, to BB-plus from A-minus and put the city on negative credit watch.
El Monte has said that it may default on Aug. 1 debt-service payments because of short-term cash flow problems resulting from the shutdown of its redevelopment agency, part of the statewide termination of redevelopment agencies.
Standard & Poor’s took similar action February when it cut Hercules, Calif., lease revenue bonds five notches to BB from A-minus, along with other city credits, after the city manager said that Hercules was teetering on the edge of bankruptcy.
Stockton has them all beat.
Moody’s Investors Service has dropped the city to Ba2 from Baa1 since city officials announced at the end of February that Stockton would default on debt and was on the edge of bankruptcy. Standard & Poor’s downgraded the city to “selective default.”
Bigger cities haven’t been immune. San Jose, California’s third most populous city, had its lease revenue bond rating cut by Standard & Poor’s last month to AA from AA-plus. Moody’s also recently dropped some San Jose lease-revs to Aa3 from Aa2.
Despite the uncertainty, concern over lease revenue bonds hasn’t been strongly reflected in pricing.
“It is just not the kind of market that would show that. It is so under-supplied versus demand,” said Matt Fabian, managing director at Municipal Market Advisors. “It really does mask the market impact of a lot of things.”
Municipal bond yields have been pushed towards record lows in a flight to quality amid concerns about Europe’s economy. And this may be creating a bubble, as investors shirk some worries, such as those surrounding lease revenue bonds.
“When investors are chasing yield, they throw caution to the wind,” Naehu said. “It is very clear that is what is happening.”