The municipal market is getting riskier. Is anybody paying consideration?
When CalPlant, a Northern California manufacturer of fiberboard made from rice-growing waste, filed for bankruptcy in October, it may not come as a surprise.
The company had issued $ 344 million in municipal bonds since 2017 to build a factory and start production, but had already faced construction overruns prior to the outbreak of the COVID-19 pandemic, according to various reports. It defaulted on a payment in 2020, but just months later it tapped existing bondholders to get more cash.
CalPlant is hardly the first special project to go bankrupt on the municipal market. A monorail that operates in Las Vegas broke twice, and the American Dream mall in New Jersey has been struggling to get started for years. CalPlant’s initial 8% interest rate bond offering and investments from high yield money managers is very different from the tax-secured, tax-free bonds sold to wealthy households simply looking to preserve their capital.
““If our market wasn’t so mundane, they would have gone to a hedge fund or a bank loan or someone’s parents for funding.””
Still, to a Muni-Market default observer, CalPlant is just the latest example of deteriorating credit quality across the market. State and local governments have been so strict on issuing bonds that bondholders are using up whatever they could get, and the laxer lending standards in project finance and riskier sectors could permeate the market.
“If our market hadn’t been so mundane, this deal wouldn’t have happened,” said Matt Fabian, partner at Municipal Market Analytics and author of the weekly default tracker. “If our market hadn’t been so mundane, they would have gone to a hedge fund or a bank loan or someone’s parents for funding.”
On the surface, the Muni market seems calm enough. In 2021, according to MMA records, there have only been 60 failures so far, not too shabby for the first full year of a global pandemic, as Fabian put it in an interview with MarketWatch. And most worked in sectors that were considered riskier even before the pandemic hit their business models, such as healthcare and senior housing.
Meanwhile, credit ratings and sectors are rising as federal funds pour into cities and states.
But Fabian points out what is going on under the surface of the market. Among other things, he notes that defaults are occurring faster than ever – in both riskier and safer sectors of the market – as lenders and borrowers alike become more aggressive.
Source: Municipal market analysis
Projects are based on shakier projections, he argues, even when issuers seek fewer ratings, if at all (the CalPlant issue was unrated and entered the municipal market as “green bonds” issued by the California Pollution Control Financing Authority) became).
Meanwhile, covenants are eroding and the time that issuers allow borrowers to review a deal is limited to hours, in Fabian’s words, “take it or leave it,” rather than the usual week or two.
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Additionally, defaults may be lower, not because the projects are more creditworthy but because, as with the CalPlant saga, “Investors are so desperate to stay invested so they can borrow more instead of forcing them to restructure. A broken issuer usually doesn’t get any fresh money. “
However, this is not a typical market. The demand for tax-exempt paper was so great that an investor called it a “food battle” in an interview with MarketWatch last May. The demand for tax-exempt paper with a little extra income is even stronger, said Fabian.
“There aren’t enough tax-exempt bonds, so the lenders capitulate,” said Fabian. “Having bonds is the most important thing. Having bonds with a thick security package is less important. “
Where is the market going from here?
Fabian believes the credit standards erosion could continue. But in a twist, he believes that rising interest rates TMUBMUSD10Y, 1.395% could be helpful in convincing some investors to stick with safer grades of Munis instead of trying more speculative paper.