Another Muni Bond Project Defaults…
Coastal Resources of Maine LLC. and CalPlant of California are two issuers of the nearly $2.4B of municipal bonds which were distressed or defaulted from January through June 1, 2020, according to Bloomberg. These issuers were pushed into distress territory as a result of the economic reverse caused by COVID-19. Both had issued non-rated “green” bonds in the last five years.
From coast to coast, at least 104 muni borrowers have skipped debt payments, violated financial clauses in their contracts or have drawn on emergency funds to cover obligations, the most since 2012, as per Municipal Market Analytics. Barclays forecasts most municipal bond defaults in 2020 will occur in hospital, nursing home and industrial projects.
Yet, credit is being bid up daily by over-eager investors seeking yield. Some bond fund managers are now sprinkling high yield muni bond seasoning into the blender with their core muni products to juice returns. A Moody’s review of 46 years of data showed that the 10-year cumulative default rate for high yield munis rated Caa-C was 26.41%. Imagine how a couple of defaults could trigger a scare and a sell-off that could slash bond prices.
Cumulative high yield muni default rates are lower than corporates, but still not pretty.
|Rating||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7||Year 8||Year 9||Year 10|
The first cohort considerd is the one-year cohort starting on January 1, 1970. The last cohort considered is the one-year cohort starting on December 1, 2016.
Transition rates are averaged over cohorts spaced one month apart.
Ratings outstanding at the time of recalibration have been adjusted to be consistent with the Global Rating Scale (see Municipal Ratings Performance Since the Recalibration of the U.S. Municipal Scale). Withdrawn ratings were not recalibrated.
Moral Hazard Is Alive and Well
With the appearance of a U.S. Federal Reserve backstop, new muni issuance continues. Investors seem to assume that the MLF (Municipal Liquidity Facility)1 established in April as part of the CARES2Act means muni bankruptcies are unlikely, but the Fed’s level of support for the muni market may not be the same as it is for the corporate bond market. While states may not be allowed to go bankrupt, projects and even some municipalities can and may.
With the worst of the worst in the muni market posting massive returns, the reach for yield is apparent. High yield Puerto Rico bonds were up 6.12% and high yield tobacco bonds were up 6.00%, in June alone. The insanity hit a fever pitch when American Airlines came to the market in mid-June with the first airline muni bond issue since November. The issue was 40 times oversubscribed. Investors were not bothered by low load factors or the junk rating.
Instead, muni bond funds posted some of the largest weekly flows on record in June, according to ICI, causing funds flush with cash to move down the credit spectrum in their bond purchases. It seems that muni investors are not concerned with defaults and tighter economic restrictions.
Choose Your Muni Bond Fund Wisely
Ask your muni bond fund manager how she is getting her yield.
The non-rated credit in the portfolio could be high quality with issues which have been escrowed-to-maturity (ETM) or pre-refunded. That means the issuer has set aside the cash to pay them off and doesn’t need a rating.
On the other hand, the securities may be unrated (NR) because the issuer didn’t want to spend $100,000 for a rating that would tell the uncomfortable truth.
Bottom up, top-down research incorporating legal and environmental, social and governance (ESG) considerations with in-depth credit research can help identify muni projects with sustainable business plans.
To hear what our Portfolio Manager David Ashley has to say about the Fed’s recent actions vis-á-vis the municipal bond market, listen to this 14-minute podcast.
For further information on the Thornburg Municipal Bond credit review process, please see our whitepaper, Municipal Bond Research: How We Do it.
1. Under the MLF, the Federal Reserve Bank of New York committed to lend to a special purpose vehicle (SPV) on a recourse basis. The SPV can purchase eligible notes directly from Eligible Issuers at the time of issuance.
2. Coronavirus Aid, Relief and Economic Security Act of April 2020.