Updated: Sep 20, 2018
September 19, 2018
Triet M. Nguyen
This past week marked the anniversary of the two most significant historical and economic events of this young century: the 9/11/2001 terrorist attacks and the demise of Lehman Bros, widely viewed as the catalyst for the Financial Crisis/Great Recession of 2008. Aside from their tragic human impact, both events drastically reshaped the public finance sector and, through the demise of many of the legacy bond insurers, led to the de-commoditization of the municipal bond market (for a high level review, we would refer the reader to an excellent piece written by our friend Tom Kozlik at PNC Capital Markets.) For our part, we thought it might be interesting to revisit these events through the lens of a long-time high yield municipal investor.
For those of us who have been involved in the high yield municipal market for a while, the 9/11 event marked the culmination of one of the greatest distressed trades ever, the "airline bonds" trade (assuming you went long, of course). By "airline bonds", we're specifically referring to the Special Facilities Revenue Bonds issued by major airports in the country and backed by many of the then-existing legacy carriers. Some of these private activity bonds were deemed "secured" by traders if they were backed by gates at major airports, otherwise they were treated as senior unsecured obligations of the guarantor airline.
As you may recall, the airline industry struggled financially during much of the 1980s and 1990s under the twin burden of high fuel and labor costs. As a result, most of the major carriers at one time or another ended up in Chapter 11, starting with Continental Airlines in 1983, followed by Eastern Airlines in 1989 and Pan Am in 1991 (the industry was characterized at the time by one of the leading street equity analysts as a "major destroyer of value".)
But it was the 9/11 tragedy that sounded the final death knell for the legacy airlines, given the way commercial jet planes were weaponized by the Al Qaeda terrorists. One of by one, the remaining airlines took their turn in bankruptcy court: US Airways, United, Northwest and then Delta. In the municipal market, United Airlines was already embroiled in another major distressed situation, as lead signatory carrier for Denver International Airport, which was still under construction at the time and was itself trading as a distressed credit due to continuing construction delays.
There was one exception to the rule, however: by cobbling together an agreement with its unions in the 11th hour, American Airlines was able to stay out of Chapter 11 for another few years, until it finally succumbed in December of 2011, in the aftermath of the Great Recession.
The airline bonds trade also marked the first successful (i.e, highly profitable) foray into the municipal market by crossover buyers who normally invest only in taxable paper. As the bonds were effectively corporate-backed, the trade made sense to the non-traditional investors who were already well-versed in corporate credits. Relative newcomers to the tax-exempt sector, such as Dallas-based Orix Corp., reportedly had great success trading airline bonds throughout this period. One can argue that the airline bonds trade opened the door to subsequent crossover interest in tobacco bonds and, perhaps fatefully, in Puerto Rico bonds.
The Great Recession also had a dramatic impact on another key high yield sector": Seniors Housing, including so-called Continuing Retirement Care Communities (CCRC). Up until then, many institutional investors had been classifying seniors living as part of their "health care" exposure. The housing price meltdown put the spotlight on the real estate risk component of CCRC credits. Potential continuing care residents were unable to move into their retirement facility as the equity in their homes vanished, with many plainly unable or unwilling to sell their residences at depressed price levels. Needless to say, this had a devastating financial impact on many CCRCs, particularly those still in in fill-up mode.
The housing collapse also created another pocket of high yield opportunity, in the guise of Land-Secured bonds, issued by Community Development Districts (CDD) to finance raw land developments, primarily in the State of Florida. According to Richard Lehmann, who spent years tracking this sector, the default rate on "dirt bonds". as they were derisively called, topped 38% by number of issues and a whopping 75% by par amount! Yet, there were relatively few trading opportunities as the mutual funds, which owned the bulk of the issues, decided to try to restructure them rather than sell into a distressed bid. That did turn out to be a smart decision as most of those CDDs have now rebounded on the back of the national economic recovery.
So, ten years after, how has the high yield municipal market changed, if at all? Well, we think it has broadened and, at the same time, become more concentrated.
For one, the line between traditional "high yield" and general market credits continues to blur. The Puerto Rico debt complex certainly deserves its own high yield category by now, but it wasn't so long ago that the rating agencies still rated Puerto Rico debt investment grade. Legal developments resulting from the Puerto Rico default and from the Detroit bankruptcy are changing the entire market's perception of the Chapter 9 process and of what constitutes a "secured" credit. If the State of Illinois and Chicago Public Schools can trade at wider spreads than a CCRC credit, the traditional definition of "high yield" tends to break down. As the public pension crisis continues to unfold, there's no doubt many more "fallen angel" credits will be slipping into "junk" territory.
An interesting corollary to this observation: there is more sneaky high yield exposure in investment grade accounts, especially in separately managed accounts (SMA), than is widely recognized by the investing public.
With the rise of the multi-billion mega issues, such as last summer's American Dream at The Meadowlands deal, the high yield sector has also become more concentrated. In the past, even sectors with high historical default rates, such as seniors living, barely caused a ripple in the market as a whole due to the relatively small individual issue size. This time around, any hiccup with any of the mega-issues is bound to have a greater impact, even more so if it occurs during a period of rising interest rates.
One thing that really hasn't changed: high yield municipal investors are still the worst at assessing commodity risk in project finance deals, judging from recent negative credit developments related to financings for facilities designed to produce wood pellets and other assorted recycled commodities, all reminiscent of the paper de-inking credit debacle of the late 1990s.
No wonder leading market observers are starting to fret about how long this high yield out-performance can last. Mike Zezas and his colleagues at Morgan Stanley argued in a recent paper titled "High Yield Stress", quite convincingly if we may add, that the current market is in fact priced for perfection, with no apparent allowance for "rating migration" risk.
Where should one look for the next area of potential high yield weakness? For one, we would start with the Seniors Housing sector, which appears to be heading toward an overbuilt situation, ostensibly as a result of an expanded new construction pipeline dating back to 2016.
According to the National Real Estate Investor (NREI) survey for the first quarter of 2018, the senior housing sector national occupancy rate reached its lowest point in 6 years to 88.8%, a 90 bps drop YOY and a 50 bps drop from 2017Q4.
This negative trend, which industry experts attribute to this year’s particularly rough flu season as well as to rising oversupply conditions, has had a greater impact on Assisted Living (AL) facilities than on the Independent Living (IL) facilities, reflecting a growing divergence between the two market segments. According to the National Investment Center for Seniors Housing & Care (NIC), AL occupancy fell to a record low of 85.7% in 2018Q1, as inventory grew 4.7% while absorption slipped to 3.2%. In contrast, inventory growth for IL facilities outpaced absorption by only 70 bps.
Away from Seniors Housing, we would also start to pay attention to the Tobacco Bonds sector, given that sector's blowout performance over the past few years (12.07% annualized return over the past 5 years, based on the S&P Municipal Bond Tobacco Index as of 9/17/18). Clearly, tobacco bond investors, particularly crossover taxable buyers, have been well-rewarded to date by adopting what we would call a ROI ("Return On Investment") approach to the sector. Instead of being scared off by the near-certainty of an eventual default, the more astute tobacco bond buyers have modeled out the various cash flow scenarios given a certain probability of default and then backed into the price on the bonds that would give them an acceptable rate of return (other investors have also noted the "perpetual" aspect of the MSA revenue pledge as security for the bonds). This cash flow approach has done much to bolster the tobacco sector's performance in recent years, with a spate of refundings providing the ultimate windfall in recent months.
One item to watch for: in recent weeks, public health sources have raised a red flag regarding the spiking rate of e-cigarette use by teenagers, spurred by the popularity of products such as JUUL, and tougher regulation by the FDA appears to be on the way. While it may be tempting to conclude that any restraint on e-cigarette use may accrue to the benefit of traditional cigarette smoking, this may not in fact turn out to be the case: higher awareness and media coverage may result in renewed efforts to curb all types of smoking, not just for electronic devices.
Interestingly, for many of the leading high yield muni funds out there, the greatest risk area may not lie in the traditional "high yield" sectors, but in their overall exposure to the State of Illinois credit cluster, which includes Chicago and Chicago Public Schools. While recent credit developments have been more positive in tone, the potential change in political leadership, both at the State and at the City level, may destabilize the credit outlook for the entire complex all over again.
Away from pure credit considerations, many market observers have pointed out the potential systemic risk stemming from an extreme concentration of high yield issues in only a couple of large mutual fund complexes. At a time when fixed income market liquidity is being questioned, such concentration may not bode well for high yield liquidity, whenever the market goes through the next correction. In all fairness however, the funds in question are acting more like private equity investors, forsaking liquidity in favor of owning a controlling stake in the event of credit trouble. God forbid you should be a minority holder of one of those mega-issues, however.
High yield muni ETFs have also become a more dominant market presence of late and it's not clear how things will unfold when they start experiencing redemptions. Since most of them have "redemptions-in-kind" provisions, the funds' market makers, rather than their shareholders, may end up with all the liquidity risk.
Ten years after the Great Recession, the high yield municipal market has become one of the best performing fixed income asset classes, a prime beneficiary of a full "risk on" environment fueled by near-record low interest rates and by the longest economic recovery on record. An extremely favorable technical backdrop for the tax-exempt market in the wake of last December's federal tax reform bill also provided the icing on the cake.
What can go wrong with this picture? Pretty much everything. Let's not forget technicals are supportive only if backed up by solid credit fundamentals. This seems to be as good a time as any to take some chips off the table and take a serious look at your holdings' liquidity or lack thereof, before everyone stampedes for the door.