Least compelling investments: How about US muni revenue bonds?

On the lookout for asset bubbles, Dan Zwirn of Arena Investors finds one part of the market characterised by potentially troubling dynamics.

Dan Zwirn

In addition to asking about those investment areas that are being overlooked, investors often ask me to opine on portions of the market that I find the least compelling – to the point of having been so overdone that the risk/reward is absurdly unfavourable, and where there are multiple plausible scenarios that could cause the proverbial “Minsky moment”.

Now, 10-plus years into a wildly inflated asset bubble with unprecedented levels of monetary authority and government liquidity creation, there are no shortage of possible answers to that question – though one interesting example fitting that profile are the revenue bonds within the US municipal market.

Revenue bonds regularly account for circa 50 percent of the approximately $400 billion of annual issuance of municipal securities[1], with about $4 trillion outstanding and a great variety of underlying revenue sources, including everything from schools and hospitals to water and sewer projects (the latter of which even has its own ETF offering). Within the 1 million-plus municipal bonds outstanding[2], there are huge numbers of small issuances that are for seemingly private businesses (versus for the public good) that never should have been municipal securities in the first place.

The process by which a project gets approved for municipal underwriting, governed by one of the 44,000 or so governmental issuing bodies in the US[3], is wrought with ambiguity. One only need glance at the multitudes of special district land bonds that are used to finance luxury home developments (or, in the case of Midtown Campus Properties in Gainesville, Florida, for the construction of “elite” student housing) to suspect that the common good is not the only criteria in securing a municipal offering.

Further, these issuers obtain a municipal backing and achieve a significantly lower rate of financing, through both their perceived greater level of safety and their tax-advantaged treatment. Given the greater ability to refinance, these issuances are generally viewed as immune from facing consequences.

That said, a day of reckoning in any number of these issuances is extremely plausible. For example, take student housing, which has averaged well over $1 billion of annual issuance for the last 15 years. What if a student housing property has no students to pay rent, such that the bond cannot pay its coupon? Well, if closely held by a small number of holders, they can all amend the paper so it is no longer in default. For example, a $10 million bond with a 5 percent coupon that can now only pay $500,000 could be replaced with a new $5 million bond paying 2 percent and a $5 million issue with PIK interest. But absent the ability to amend, extend and/or pretend, the fate of that property might more resemble that of the dormitories in Gainesville, which defaulted as a casualty of covid.

A more severe crisis may be in the works, based on several near-term catalysts – such as the leap-frogging of consumer and business behaviour brought on by the pandemic, potential state and local government insolvency, or idiosyncratic credits that should never have been eligible for the guarantee in the first place (which is likely where you will see the problems manifest first).

Or maybe not. Typical distressed cycles create borrowers with solvency that lack liquidity. Today’s market is unique in that, with the wanton intervention by monetary authorities and governments, there are ample cases of the opposite – insolvent entities that have ready access to liquidity – with municipal issuers as a prime example. After all, the market can be irrational longer than you can be solvent, and Jerome Powell need only sneeze a sound resembling “muni” to suggest the reinstatement of the previously approved Municipal Liquidity Facility, or Nancy Pelosi, now reinstated as speaker of the House, achieving her goal of massive federal funding for state and local government aid.

But widespread issues aside, for those with the ability to comb through the scores of issuers, there will be many opportunities to refinance or purchase positive-value assets and obligations following those situation-specific events. And given how overdone this area has been, I would not be surprised if those opportunities persist for the better part of our investing careers.

Dan Zwirn is chief executive officer and chief investment officer of Arena Investors, a New York-based investment firm

[1] Source: sifma.org

[2] Source: SEC:  Investor Bulletin: The Municipal Securities Market

[3] Source: SEC:  Investor Bulletin: The Municipal Securities Market