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Fixed-Income Insights

While municipal bond investors focus on headlines about general obligation issuers, they may be missing compelling opportunities in revenue bonds.

 

In Brief

▪ Many investors think that general obligation [GO] bonds largely represent the broader municipal bond market. So, these investors allow headlines about GO issuers—especially those surrounding budget and pension questions— to influence their perception of the entire muni market.

▪ But GO bonds represent only about 25% of municipal bond issuance, according to The Bond Buyer. The rest of the market is composed of revenue bonds. Investors who focus on the latest developments in the GO sector may not realize the range of opportunities within the revenue-bond market.

▪ A close look at six revenue-bond deals—two each within the high investment-grade, low investment-grade, and below investment-grade ratings categories—illustrates the diversity of the issuer base.

▪ The key takeaway— Municipal bonds provide attractive tax-exempt income and total returns through a range of investments that provide more credit diversification away from headline budget and pension issues than investors might expect.

 

When analyzing the municipal bond market, many people focus on just one type of muni issue: general obligation [GO] bonds. The popular perception is that GO bonds largely represent the investment environment for the entire muni-bond market. From that vantage point, then, the financial health of the states and cities that issue them weighs heavily on the overall muni sector. This commonly has been the situation in recent years, as questions frequently arise about how governments will balance their budgets and fund their pensions.

These questions certainly deserve thorough analysis, but they receive a disproportionate share of attention from investors. That’s because GO bonds represent only approximately 25% of municipal bond issuance, according to The Bond Buyer. The remaining majority of the market is composed of revenue bonds, backed by specific sources of funding rather than the full faith and credit of a government. 

Over the past few years, prices of muni bonds often have fluctuated significantly based upon news such as incorrect forecasts of widespread GO defaults (like the now-infamous call by analyst Meredith Whitney in December 2010) or isolated reports of state pension-funding difficulties, even when they are not necessarily widespread and don’t directly impact many revenue bonds. As we noted earlier, market consensus is typically focused upon questions surrounding high-profile GO credits. Indeed, many investors make decisions about whether to put their money into the asset class based solely upon news about the GO category.

The Bigger Picture
But these investors are most likely missing the bigger picture. They may not realize that there are a wide range of available municipal bond investments beyond GO issues. Further, they may not be aware of the opportunities to receive attractive long-term returns, along with tax-exempt income, by investing in mutual funds that maintain a diverse set of holdings in a range of muni-bond sectors and are, therefore, not as heavily reliant upon GO credits as many might think. That diversification could serve investors well, even if a few GO issuers face difficulties down the road.

Because GO bonds receive so much attention, potential investors may not be aware of the importance of revenue bonds—not just in terms of their potential investment benefits but also for how often they are used to finance much of the infrastructure in the United States. This unawareness also may be true of many elected officials in Washington, because they typically are more focused upon the kinds of investors who are receiving the benefits of the tax-exempt interest rather than the underlying purpose of munis. In the case of revenue bonds, that purpose is to finance projects which touch many important aspects of everyday life.

Typically, municipal entities do not have the cash to pay for everything they need, so they borrow through the municipal bond market and pay creditors back over time with revenues generated by the people using the projects. Some essential services and amenities financed by revenue bonds include transit systems, bridges, water systems, utilities, airports, commercial buildings, museums, universities, not-for-profit hospitals, toll roads, stadiums, senior living facilities, and schools. And the list goes on and on. 

The Road to Revenue
If an investor were to understand this financing system, he or she might change their perception about what it actually means to invest in municipal bonds, and how he or she might react to the ongoing headlines about municipal credit. For example, let’s say you’re stuck in heavy traffic during a busy summer weekend on the New Jersey Turnpike. Rather than only becoming frustrated, you can at the same time also consider the fact that the drivers you see around you are paying a lot of tolls to be on that road. Further, it just might be possible that a mutual fund you own has investments in New Jersey Turnpike Authority bonds, so the traffic actually could be helping your portfolio. (See, there can be a bright side to a traffic jam after all.) Also, if you are concerned that your water and utility bills are rising, remember that they could be even higher if the borrowing to maintain those systems was not done at tax-exempt interest rates in the municipal bond market.

Investors in municipal bond mutual funds typically receive income and total return from a diverse set of bonds. If fund groups have strong research units, they have the capability to invest in a wide range of sectors, and this typically means more revenue sectors. This diversification can occur in both a fund focused upon investment-grade bonds or one in the high-yield category. Some portfolio managers have a preference for revenue bonds over general obligation bonds because the sources of money to pay interest are better defined and more predictable, allowing for deeper financial analysis of future outcomes.

To highlight these types of investments further, let’s take up some representative examples of revenue bonds, two each from the high investment-grade, low investment-grade, and below investment-grade ratings categories. While this provides only a small sample of the revenue-bond universe, a brief look at these issuers could provide some extra insight regarding what it means to invest in municipal bonds beyond the typical focus on state and local government general obligation issues.

High Investment Grade
Minneapolis-St. Paul Airport Commission (S&P Rating: ‘AA-’)
Many airports around the country use municipal bonds to finance their construction needs, primarily because they do not have the funds for large projects. Tapping the muni market allows them to use their future revenues to make payments on the bonds. Many large airports such as Dallas-Fort Worth and Chicago O’Hare are rated at the ‘A’ level by major credit rating agencies, reflecting their high debt levels because they have needed to finance many capital projects over the past few years. Airport revenues typically include airline fees, passenger facility charges, and general concession fees.

Minneapolis-St. Paul Airport is on the higher side of the ratings scale. It is the sixteenth busiest airport in the United States and is comprised of the main airport and six smaller facilities. Because of its geographic location, there aren’t any large competitors nearby. It is a hub for Delta Airlines, which has a large market share at the airport and serves connecting traffic as well as origination and destination passengers. Connecting traffic can be a credit risk for other airports; however, this hub is important to Delta due to its central location. The airport has strong, longstanding contracts in place with Delta. 

Regarding its financials, Minneapolis-St. Paul Airport has a good amount of cash and low levels of debt compared with other airports. Also, it does not have much new borrowing planned in coming years, and it is a relatively low-cost facility for airlines to use. Overall, we consider it a solid credit due to its market position, strong financials, and geographic importance.

California Health Facilities Financing Authority—Sutter Health (Moody’s Rating: ‘Aa3’; S&P Rating: ‘AA-’)
Many not-for-profit hospitals borrow in the municipal bond market to finance capital projects such as facility expansion. They pay the interest over time through the revenues earned at the facility. This sector has a wide range of credit quality. Some issuers may be rated below investment grade, such as a small stand-alone hospital in a small market or one located in an inner city with a high proportion of indigent patients. On the other end of the ratings spectrum, there are many large, well-managed, and well-positioned hospital systems that provide lower risk investments with more yield than similarly rated general obligation bonds.

Sutter Health in California is an example of an investment on the high end of the credit-quality spectrum. It is a large healthcare system with more than $10 billion in annual revenue, 31 hospitals, and an extensive physician network. Sutter has a strong, stable market position. It has a diversified revenue base due to having facilities in multiple markets as well as its position as a regional leader in a large number of medical specialties, such as orthopedics, cardiovascular services, and cancer care. Sutter has maintained stable debt levels in spite of making significant investments in its facilities, along with a multiyear trend of positive cash levels and operating margins. Since the implementation of the Affordable Care Act, many hospital systems around the country have been expanding their networks, both through organic growth and acquisitions, in order to achieve economies of scale and thereby optimize operating margins. Since Sutter Health already has the size and market position, it is well prepared for the current healthcare environment.

Low Investment Grade
California Pollution Control Financing Authority—Poseidon Resources (Moody’s Rating: ‘Baa3’)
The municipal bond market can be used for a range of project finance deals. These credits often end up in the lower tiers of the investment-grade range because there is construction risk, typically coupled with an extended time period necessary to determine whether projections can be met. These types of deals can represent attractive opportunities for mutual funds that can approach investing in a diversified manner, supported by experienced research analysts. Each investment can provide attractive tax-exempt income to investors, but these types of issues are best used in a diversified portfolio, in which each holding does not account for too high of a percentage of the total.

One example of this type of investment is a project with Poseidon Resources and the San Diego County Water Authority through the California State Pollution Control Financing Authority. They are constructing a desalinization plant to convert ocean water into potable water for use in the San Diego metropolitan area. The desalinization plant is a relatively expensive source of water, but it will help to diversify these entities’ sources and mitigate historical and heavy reliance on water imported from the California State Water Project. The desalinization project was started many years ago, but it has become more important over time in light of the multiyear drought that recently prompted California governor Jerry Brown to put emergency measures into place.

The most significant risks are the construction period and the effectiveness of the technology, of which this particular kind has been used only in a few desalinization plants around the world—and would be the first of its kind in the United States. When we consider bonds in this category, we work to mitigate these concerns by evaluating the contractor’s experience and the contracts that govern the project. The contractors, J.F. Shea and Kiewit Infrastructure, have more than 100 years of experience in complex civil engineering projects. Also, the contracts include payment penalties if the builder does not complete the project on time. Further, San Diego County Water Authority has agreed to pay for the project as long as it operates at 60% of estimated capacity. Construction began in 2012, and has an estimated completion date for the fourth quarter of this year. So far, the project is on time and on budget.

Pennsylvania Economic Development Financing Authority—Pennsylvania Bridges (S&P Rating: ‘BBB’)
Many politicians and pundits have been commenting about the country’s infrastructure needs. One key point that is rarely included in those discussions is that the municipal bond market historically has been one of the primary methods to finance those needs. This recent deal was part of a public/private partnership in response to the significant repairs needed for bridges around the state. In recent years, there have been an increasing number of public/private partnerships (also called P3 deals) for infrastructure. Pennsylvania decided to use a private company to do the work in an attempt to shorten the amount of time, money, and disruption to the public necessary to complete the projects.

This financing will be used to repair and reconstruct 558 structurally deficient bridges across Pennsylvania, and will take more than two years to complete. In addition to the money borrowed through this bond issuance, the private partners provided substantial equity before the building started. These partners are experienced in this sector, because they been involved with other municipal bond projects. In particular, there have been several issuances in the toll road sector that have included private backers. 

The repayment for bond investors will come primarily from the state’s Motor Vehicle License fund and, if needed, from federal transportation funds. If that still is not enough to cover the needed payments, then money from the state’s general fund can be appropriated for the balance. This source of funds makes this bond issue an interesting credit to analyze, since it has a ‘BBB’ rating due to the construction risk—the cost and time to complete the entire project—along with the public/private nature of the deal; but it also indirectly has some potential backing, if necessary, from the state, which is rated in the ‘AA’ level.

Below Investment Grade
Iowa Finance Authority—Iowa Fertilizer Company (S&P Rating: ‘BB-’)
When moving into the below investment-grade portion of the municipal bond market, there are a wide range of projects, in many different sizes. These projects take rigorous analysis, but they can provide attractive tax-exempt income and total return for investors who can gain an understanding of the risks. Most of the attention in this part of the market has been focused upon the large, downgraded issuers such as Puerto Rico or some of the smaller, colorful deals in which default rates have been higher. This Iowa deal was issued in 2013, and at the time, it was the largest new issue in the high-yield municipal bond market.

The Iowa Fertilizer deal is financing the construction of a nitrogen fertilizer plant in a small town in Iowa. There is a large market for fertilizer because it represents approximately 12% of farming costs and there is not enough of it produced within the country. Within the United States, the bulk of fertilizer use is in the Midwest, with Iowa being the largest state for use. Currently, more than half the fertilizer used in the Midwest is imported from around the world, and nitrogen fertilizer is by far the most heavily used type. For farmers, being able to source the fertilizer domestically will lower costs, compared to buying from other countries, so there should be solid demand for this product. 

The biggest risks for this project are the demand, which seems to be there, but is not certain, and the construction, which could have issues with cost and timing. Construction is currently about two years into the projected three-year timeframe. The operator building the plant is experienced, which is a positive, and the barriers to entry for competitors are challenging because the process from planning through construction takes five to six years. There are a few other plants currently being built, but the total projected production of fertilizer from these new facilities is not nearly the size of overall domestic demand. This deal was able to be financed with tax-exempt bonds because it was part of a disaster relief plan to bring jobs and economic development to the area. It now is one of the larger issues in the Barclays High Yield Municipal Bond Index.

3 World Trade Center (not rated)
Last year, the high-yield municipal bond market saw its largest new issue: the bonds to build a new office tower in lower Manhattan to replace the World Trade Center. The project was financed by tax-exempt municipal bonds because it was part of the Liberty Bond program to redevelop the area. This deal has several different classes of bonds with different levels of credit risk. It can be tough to differentiate the classes, because none of them are rated by the credit ratings agencies. While in other fixed-income markets it might be unusual to have non-rated bonds, in the Barclays High Yield Municipal Bond Index, more than 30% of the credits are not rated, so this is not something unusual for municipal bonds. The bonds often are not rated because they do not fit into a typical sector for a rating agency or because there might not be any economic benefit for the issuer to pay for the below investment-grade rating. This feature of the market can provide attractive tax-exempt income for investors who have the capability to analyze the range of credits.

This deal finances the construction of the new building 3 World Trade Center (WTC), which will have 80 floors, along with a good amount of retail space. The retail space does not support the bonds, but it is part of what likely will make the location attractive to potential tenants. Construction is expected to be completed by the first quarter of 2018. There is a good amount of competitive new real estate in the area, but the building was 20% leased before it was even built out, and demand is expected to increase when it is closer to being completed. Also, each class of the bonds depends upon different levels of occupancy to be paid, so it does not need full occupancy for the investment to be successful. 

While the 3 WTC bond issue is not a credit of the Port Authority of New York and New Jersey, the Port Authority is actively involved in the finances of the development. For companies considering the office location, the cost per square foot is lower than it is in midtown Manhattan, and the location with a rebuilt transportation center nearby can provide some extra benefits; but the main risk after the construction phase is attracting tenants. This is currently the largest credit in the Barclays Municipal Bond Index and, because of its size, the market is very liquid for the bonds, with many dealers regularly quoting markets, which is unusual for municipal bonds, particularly on the high-yield side.

Areas of Opportunity
These are just a few of the many examples of municipal bonds available to investors other than general obligation bonds. It should be clear too that there is a wide range of types of investments available, along with many purposes that benefit all population segments of the country. It would take much space to describe fully all of the investments available, because they encompass so many sectors, including water, sewer, utilities, housing, healthcare, transportation, real estate, corporations, and not-for-profit entities. We hope these bond deal descriptions can give investors a fuller understanding of the market, and inform them that there are many strong investments that are not connected to the pension or budget issues faced by a few GO issuers. These well-publicized difficulties seem to garner most of the attention from those who search for headlines regarding the market.

Several years ago, when the GO debt of California was downgraded at the state level, most of the revenue bonds in California began trading at cheaper levels because of concern about the state’s finances, even though the revenues supporting most of the bonds were not connected. As California’s fiscal situation has improved, and its credit rating upgraded, all bonds in California have benefited. The advantage of the revenue bonds is that they were available at cheaper prices, even though their credits were fine and were not likely to be affected by changes in the state’s fiscal status. 

Currently, Illinois and New Jersey are subject to similar concerns about each state’s general obligations. Many muni bonds in these states have underperformed as a result of these concerns, but do not have credit issues due to state problems such as private universities. Investors are most likely penalizing them simply because they are located in the same state. This development could present opportunities for investors who can analyze these revenue sectors and maintain an appropriate focus on the fundamentals of individual revenue issues rather than state-level fiscal concerns.

We hope we have provided you with some ideas to think about as you consider and review your investments and as you travel around the areas where you work or live. A tour of the Chicago area, for example, might reveal many attractive investment opportunities, even though the City of Chicago and the State of Illinois are trying to solve pension and budget issues that have placed negative outlooks on their credits. So, as you review the holdings in your mutual funds or look at bonds available for purchase, you may find it worthwhile to learn more about alternatives to general obligation bonds—and the wide range of investments that can be made when purchasing municipal securities that have less exposure to the headline budget and pension issues than you might expect.

 

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