PHOENIX – Land-secured municipal bonds, considered among the riskiest, are benefiting from shifts in market practices and macroeconomic trends that have helped reduce defaults to zero so far this year.
Data compiled by Municipal Market Analytics and released last month showed no new land-secured bond defaults through the first two months of 2016, and that the number of first-time payment defaults has dropped from 50 in 2012. The sector has been “far and away” the biggest muni defaulter, MMA found, accounting for about 40% of the more than 800 payment defaults MMA has tracked since 2009.
Land-secured bonds can take several forms, but are often special-assessment debt such as “Mello-Roos” bonds in California, named for the state lawmakers who pushed to authorize that type of financing in 1982. They are often issued by single-purpose entities set up to finance a specific project, and sometimes refinance initial bank loan financing. The sector has been viewed as risky, because many of those financings were “bare land” deals, secured by taxes on a development such as housing that was not yet built or occupied. Investors have sometimes found such deals attractive because they offer yield, even though they will default if the development fails to meet expectations.
“They can be very delicate in their initial life cycle,” said Matt Fabian, a partner at MMA. “Bond holders are taking the same position as the developer. The project needs to develop or they will default.”
Tom Schuette, a partner and co-head of credit research and portfolio management at Gurtin Fixed Income, said his firm views the sector as volatile even when projects have passed the bare land phase of development.
“These are very risky when first issued,” Schuette said. “Investors are basically buying a corporate bond when the projects are in the speculative phase given that bondholders are entirely reliant on the developer at that point. Additionally, there have been any number of things that have led to credit events historically that take place between the point when bonds are sold and the project is actually mature or built-out; namely environmental issues or other permitting problems that result in development being delayed or unable to proceed according to the original plans.
“Secondly, even after development begins, we are often concerned about the size and concentration in these land-backed deals,” Schuette continued. “Investors often do not realize that the tax bases are exceptionally small and highly concentrated in just a few taxpayers. These factors greatly increase credit risk – just a few large taxpayers’ delinquencies can result in a technical or monetary default.”
Fabian said that many investors in the sector are high-yield buyers like mutual funds who have their portfolios diversified across the land-secured sector, and understand that the bonds are often structured as a very speculative investment. The market dwindled during the great recession, when many of Florida’s community development districts defaulted and Mello-Roos financing in California slowed to a virtual stop. The market has since rebounded, but experts said the structure of these deals and investor behavior have changed.
Anna Sarabian, a partner Fieldman, Rolapp & Associates, said investors are now smarter and don’t have the same appetite for the riskiest types of land-secured bonds issued before projects have become realized.
“You don’t see projects that are just raw land deals,” Sarabian said. She added that she did not expect another wave of defaults even in the event of another recession, because the bonds simply wouldn’t be issued in the first place.
“In a recession, any new projects will be almost down to zero,” she said.
Fabian said there is just less speculation on real estate now than there was during the mid-2000s, and that the defaults that do happen in the sector are now typically structural and more micro-level. MMA sees the decline in defaults as a positive for municipals and particularly for high-yield munis, Fabian said. If the trend continues it could justify tighter spreads and better demand in the sector, he said. The decline in defaults could signal an improvement in residential real estate markets in the states most associated with land-secured debt over the past few years, MMA added, including Florida, Colorado, and Nebraska.
“The decrease in default rates may be a temporary natural consequence of developers and special districts proceeding cautiously after the housing downturn and recession,” Schuette said. “Macroeconomic trends may have temporarily suppressed some of the more risky and speculative projects from moving forward. Regardless, we believe the fundamentals of this sector are critical as opposed to any short term blips in default rates. Buying bonds backed by a developer’s speculative plans is a much different investment focus than buying high-quality municipal obligors in the market’s more resilient sectors.”
