LOS ANGELES — They didn’t plan it that way, but the decade of delay the builders of a seawater desalination plant experienced getting the Carlsbad, Calif. project off the ground landed them in one of the most receptive markets for high-yield municipal bonds in recent history.
The owners of Stamford, Conn.-based Poseidon Resources plan to price the debt through the California Pollution Control Financing Authority Dec. 20. The $781 million in tax-exempt bonds come with ratings of BBB-minus from Fitch Ratings and Baa3 from Moody’s Investors Service.
“It has been a very strong sector of the market,” said Craig Brothers, a managing director at Bel Air Investment Advisors Inc. “That is probably another reason they are bringing this deal to market now, because the environment is better than it has ever been.”
Indicators tracked by Caprin Asset Management to gauge increased demand are demonstrating an increased appetite for high-yield municipal bonds, according to Peyton Studebaker, head of trading.
One indicator Caprin tracks is the rise in market capitalization of the High Yield Muni exchange-traded fund “HYD.”
The market cap in that ETF has grown from approximately $340 million at the beginning of 2012, to now over $1 billion—an increase of 201%, Studebaker said in an email.
“This is a testament to both investor appetite for more income from the high yield sector and the growing popularity of the fixed income ETF space,” he said.
The second indicator Caprin monitors is the flow of funds into high-yield municipal mutual funds. According to Morningstar Analytics, approximately $12.3 billion has been added to these funds year-to-date through November. That is an increase of approximately 23%, compared to 2011 when investors added approximately $3 billion, a 6% increase.
“This trend continues to show that investors are seeking out incremental yield still available in this low nominal yield environment, and that they are willing to take on the added credit and duration risk that typically go along with these funds,” Studebaker said.
The last time Brothers remembers seeing spreads this narrow was in 2005 – and he can’t remember how far back beyond that such an event occurred.
Fitch analysts said the bonds land on the lowest rung of the investment grade ladder in part because they involve technology not widely understood, and construction risk.
The project, a reverse osmosis seawater desalination plant on a six-acre plot leased from the Encina Power Plant in Carlsbad, is designed to produce 54 million gallons a day of water. Poseidon will also construct a 10-mile pipeline.
Projects like this have sold at rates lower than expected, because investors are looking for yield, said Mike McDermott, a Fitch managing director.
Poseidon received approval on Nov. 29 from the San Diego County Water Authority’s board for a $3 billion purchase agreement in which the water authority will purchase 56,000 acre-feet of water annually.
The following day, the California Pollution Control Financing Authority agreed to act as conduit issuer on the bonds, which will be sold in two series.
There are $221 million in tax-exempt governmental bonds issued on behalf of the water authority to finance construction of the 10-mile pipeline, and $559.8 million in tax-exempt private-activity bonds for Poseidon to finance construction of the plant.
If Poseidon fails to provide the amount and quality of water agreed to or doesn’t open on time, it will be responsible for debt service on the bonds being issued for the water authority.
SCDWA will be the primary obligor of the pipeline bonds payable under an installment agreement starting after the plant and pipeline are up and running.
The water authority bonds for the pipeline received the same BBB-minus rating as the plant bonds, even though the authority has AA ratings from all three rating agencies, because of the construction risk involved, said Scott Zuchorski, a Fitch director.
The environment to bring to market what everyone considers a complicated deal could not be better, Brothers said.
“You need this kind of market where there is a huge demand-supply imbalance and money is flowing into bonds month after month,” Brothers said.
The high-yield market has outperformed all other sectors in the muni market and the corporate market because of the yield compression taking place, he said.
With interest rates at historical lows, investors are starting to reach for yield, going out longer on the curve and dipping down into the high-yield category to get some income, said Triet Nguyen, managing partner of Lake Forest, Ill.-based Axios Advisors LLC.
“If you look at the performance of the high-yield municipal market this year, it’s pretty outstanding,” Nguyen said.
Further limiting the buyer pool, the bonds are only being offered to qualified institutional buyers in denominations of $250,000; and can only be re-sold to the same kind of buyer in similar denominations limiting liquidity.
Brothers categorized the bonds as “something that has to be bought and tucked away—it’s not something you can trade.”
Even though it’s the right kind of environment, it will be a tough one to get done, he said.
“It is not the kind of deal that just gets priced and sold,” Brothers said. “Bankers earn their keep by being available for people who want to ask questions. The sales staff has to identify who are the potential buyers and flesh that out before bringing it to market.”
JPMorgan is the lead underwriter.
Barclays Capital, Bank of America Merrill Lynch, Goldman Sachs & Co., and Stone & Youngberg, a division of Stifel Nicolaus, make up the rest of the syndicate pricing the bonds.
The pollution control authority required that the bonds only be sold to QIB’s to limit the pool to sophisticated investors, who can appreciate the risk, said Bill Ainsworth, a spokesman for the California treasurer’s office, which staffs the authority.
“They want buyers to do the work and understand that they face a better yield situation, but it’s not an A-plus credit, it’s a project finance credit,” said Sandy Kerl, deputy managing director of the San Diego County Water Authority.
Despite the limitations on the bonds, Kerl said they have received a lot of investor interest since the offering documents went out Dec. 3.
The 10-year delay resulted from the hurdles Poseidon cleared to obtain financing and reach a resolution on a half dozen lawsuits brought by environmental groups.
Andrew Kingman, Poseidon’s chief financial officer, said a bond issuance was the only way to get long-term financing at a fixed rate.
“If we had gone to the bank, there would have been refinancing risk at some point,” Kingman said.
Orion Water, a partnership formed between Poseidon Water LLC and Stonepeak Infrastructure partners LLC, will be making an equity contribution of $172.6 million, which represents approximately 18% of funding sources, according to the Fitch ratings report.