Robust Demand for Taxable and Tax Exempt Municipals Bonds Will Fuel Issuance in 2021
We have reached the point where interest rates have become sufficiently low that the viability of issuing taxable municipal bonds to refund higher coupon tax-exempt bonds in an issuer’s capital structure has become an active strategy. In December 2020, the California Infrastructure and Economic Development Bank came to market with a $325 million Taxable Municipal Bond offer to refund prior tax-exempt bonds. While revolving bond fund issuance is the norm for the tax-exempt municipal bond marketplace, the structure is less common to taxable/ investment grade investors.
The bond issue was highly rated — (NR/AAA/AAA). The foundational strength of the ratings emanates from the collateralization structure and the diversified pool of participants. Fresno Airport (8% of the portfolio), the city of San Bernardino and the Los Osos Community Service District are good examples of municipal borrowers of the Fund, yet two have filed for bankruptcy and all three borrowers are portfolio credit concerns (Fresno Airport has been impacted by the Covid-19 pandemic and needs additional federal aid).
Municipal Bond Issuance by Type
Taxable municipal bonds issuance is viable because of the versatility it provides an issuer. The advantages to the issuer are clear, the first being the elimination of the arbitrage restrictions, a priority to avoid when issuing tax-exempts because a tax-exempt bond issue could be declared as taxable for violating the arbitrage rules. Reserve funds created from bond proceeds can be invested in other low risks/low volatility assets rather than investing only in the paltry yield offered by cash equivalent investment vehicles. Pension Bonds benefit from the absence of arbitrage restriction rules and the bond proceeds can be invested in higher earning asset classes such as traditional and private equities. The income and gains from the arbitrage can be applied to offset annual contributions from governmental revenue sources. An examination of the asset allocation of many state and local retirement plans shows plan asset allocations of 50% or more in equity securities. Higher cash weighted returns reduce the amount of annual contributions that would normally be made and thereby reduce fixed expenses as a percentage of revenues. Taxable municipal bonds provide much greater flexibility, and the cost is not financially punitive because of the low level of interest rates.
Taxable Appropriation Debt Issuance
In recent months, California cities such as West Covina and Ukiah have monetized city assets and used the proceeds to fund their CALPERS payments. The debt service repayments will be made by annual appropriation and will be part of the annual budget process. Appropriated debt is not equivalent to an issuer's GO debt and is generally considered to be one notch below GO-backed debt. Failure to appropriate can impair the GO rating and while rare, has occurred in recent years, most notably Platte County, Missouri. Cross over buyers must be aware that the bond rating does not necessarily address embedded appropriation risks; distinctions must be made and the budgetary process examined. For example, is the appropriation process based on an aggregate amount, or is the process done on a line-item basis?
ESG and Green Bonds
The State of Michigan plans to issue approximately $600 million in taxable state appropriation debt to partially fund the settlement payments to Flint, Michigan for the water crisis that plagued the City for several years.
Investors’ preferences are evolving. ESG and Green investments have taken on increased importance to socially conscious investors domestically and abroad. Understanding the characteristics of ESG and Green Bonds, experience and analytical capabilities are key components.
Recent California and New Jersey bond issuance included ESG taxable tranches. The additional feature brought non-traditional municipal bond buyers into the muni marketplace. This is positive on two fronts. It expands global interest in the municipal market with more investors. Over the longer-term, the expanded market participation should enhance trading efficiency and improve liquidity. We think that municipal issuers with proven operating histories will consider using taxable tranches because it will broaden the demand for their securities, which could have the effect of lowering borrowing costs. Mid-grade and highly rated municipal bonds still enjoy significantly lower default rates than comparably rated corporate bonds.
The health care sector may find taxable municipal bonds beneficial. Several hospitals such as St. Louis Children's Hospital and Boston Children's Hospital have substantial endowment assets, accumulated from active fund-raising campaigns to build assets as a buffer against reimbursement rates from third-party payers and funding indigent patient services care services. Strong equity market performance has enhanced the value of these assets, but with the upside comes volatility. Analysts will be required to disaggregate the equity investments in the portfolios and analyze the implied portfolio risks and impact to credit quality. Understanding the operating fundamentals must also be paired with portfolio analysis. Most CCRCs also shave endowment assets which are an important operating component to the finances and credit quality.
High Yield Municipal Bonds
The High Yield sector can be challenging to navigate because of its breadth and diversity. Sector expertise is a critical piece of the analysis process. For example, with project finance there may be few, if any, directly comparable projects in operation. Also, new technology issues may not have an established and meaningful track record. Muni analysts must incorporate operating criteria from their corporate counterparts. Many high yield bonds are non-rated and there may not be any representative cohorts, a process that rating agencies exercise in their rating process.
High yield tax-exempt bonds remain an attractive asset class. This class of bonds can provide incremental yield spread and allows investors to receive higher coupon yields and, in many instances, up to 10 years of call protection, a feature that may not be as readily available in the corporate high yield sector.
Certain Project Finance high yield offerings may be classified as either ESG or Green, depending on the specific use of bond proceeds. In either event, the analysis will require a high degree of sector expertise. Covenants, the flow of funds, and the level of initial working capital reserves are essential components for start-up ventures. They provide bondholders with added protection during the initial ramp-up period. Replenishment covenants and maintenance of specific reserve funding levels are critical requirements that can act as a buffer before accessing the debt service reserve fund in the event of stressful unforeseen challenges that can occur with start-ups. Parity debt covenant should have both prospective and historical tests to protect existing bondholders and impose a standard of financial discipline.
Lastly, equity contributions in the form of tax incentivized equity capital such as New Market Tax Credits, Historic Tax Credits, Opportunity Zone equity investments, and subsidized energy credits can help to reduce fixed borrowings and are essential elements of the capitalization structure. The timing of receipt of these equity capital injections during the initial or -start-up phase is the preferential financing method rather than drawing down bond proceeds during the ramp-up period. Lastly, the disbursement process of bond proceeds by the Trustee must be specific and have independent third-party oversight, with explicitly clear standardized work change order requirements as preventive measures to avoid unexpected increases in construction costs. The primary goal is to avoid being in the tenuous position of being unable to complete the project because of inadequacies in the oversight process.
The new year will present a series of new issues and challenges for the High Yield Sector. The availability and access to timely information and data will raise the surveillance bar. Secondary trading activity evaluations will also benefit from the quality and timeliness of continuing disclosure. Issuer press releases, the quality of issuer websites, and local news sources can provide useful information during the assessment and monitoring processes. The expansion of the municipal universe brings additional investor oversight, methods that should improve market efficiency.
Tax Supported Municipal Debt Issuance will remain Robust
While the initial focus of high yield municipal bonds is often revenue bonds, tax-supported bonds will remain well represented in the marketplace. Carve-out revenue structures may proliferate as many municipalities may seek to pledge narrower revenue sources proven to be Covid-19 pandemic resistant.
Scoop and toss refunding strategies to push short-term maturities to later years could provide near-term budgetary relief as a way to better match future revenues with future expenses. This could be a useful strategic tool for many local governments — especially local governments with Covid-19 related revenue shortfalls.
Infrastructure investing will also contribute to the breadth of the municipal bond universe. State and local governments will be issuers, but their issuance capacity will be largely influenced by their ability to fund their matching portion. The public-private partnership structure will be prevalent as a vehicle for local governments to fund their matching portions.
In June 2020 U.S. Department of Transportation announced the Trump Administration would invest $906 million in America’s infrastructure through the Infrastructure for Rebuilding America (INFRA) discretionary grant program, with proposed funding awarded to 20 projects in 20 states.
Demand for the grants was robust. DOT evaluated 173 eligible applications from 47 states, as well as U.S. territories and the District of Columbia, who collectively requested approximately $7.4 billion in grant funds—more than eight times the funding available.
Infrastructure projects have long enjoyed bipartisan support, often nicked named pork-barrel projects that allow elected officials to bring home the bacon in their district or state. However, that practice appears to be evolving. The Biden Administration has stated that infrastructure will be a key component In addition to sector diversification, infrastructure municipal bonds will also bring geographical diversification for many portfolios because of the broad national need for infrastructure to stimulate lethargic economies impacted by the pandemic.
The Municipal Bond sector’s growth and diversity will continue and will be well supported by global demand.