The Funny Calculus of High Yield Tax-Exempt Investing

June 15, 2017

Triet Nguyen

The high yield municipal market is staying true to its reputation as the lender of last resort. Where else can a financing that the taxable CMBS market has reportedly refused to endorse for more than a decade resurface and in all probability get placed?

We’re referring, of course, to the marquee unrated deal of the week, and probably of the year: the $1.1 billion financing for the American Dream Mega-Mall at the Meadowlands, consisting of an $800 million Public Finance Authority (PFA) PILOT Revenue issue and a $300 million New Jersey Sports & Exposition Authority (NJSEA) Grant Revenue issue.

To put things in the proper perspective, the underpinnings of the high yield tax-exempt sector are currently in pretty decent shape. Flows into the high yield muni funds have been steady, if unspectacular, and aside from a few fallen angel names (think CPS, State of Illinois and the Westinghouse-related muni utilities) there has been a dearth of really “yieldy” deals. Eric Kazatsky from Bloomberg Intelligence recently made a good case for the sector, arguing that “while the corporate and muni markets are dissimilar from a liquidity standpoint, the additional 250 bps in tax-adjusted yield” (by Eric’s computation)” could attract non-traditional buyers to the space” (Eric’s daily column on Bloomberg Business Intelligence is a must-read, by the way).

In this context, crossover players may indeed be attracted to the American Dream deals by virtue of their size and potential “liquidity” (although such an approach didn’t exactly work out in the case of their Puerto Rico investments). They may also be aghast at the absence of any bondholder protection, which we discussed at length in our June 1st issue. This is a bit ironic, since these issues literally cannot default: not because their creditworthiness is stellar but because the indenture prevents bondholders from declaring an event of default or from accelerating the debt in the event a coupon payment is missed! A neat trick from the underwriters, one must admit.

As of Wednesday June 14th, the preliminary price talk on the PFA deal was reportedly around 6 1/4% in 2050 at par and on the NJSEA deal, 5 7/8% in 2031 at par. At close to +350 bps compared to 30 year Treasury yields in the case of the PFA issue, this preliminary scale is certainly worth consideration from non-traditional buyers.

If all this sounds like a lot of negativity on our part, nothing is further from the truth. We fully appreciate that, if you’re an institutional player in the high yield municipal space, you must participate in transactions of this type, especially if they are going to be included in your performance index, as these undoubtedly will. As usual, the name of the game is to figure out how many tax-exempt coupons you can collect before credit problems start, and how much of a hit to net asset value you can afford in the overall context of your portfolio. If you play it right and keep your potential exposure at a “manageable” level, whatever that may mean, the incremental yield you gain from this investment may bring in enough new assets to actually dilute the potential impact of any future credit problem. Such is the current calculus of high yield muni investing, and it has worked beautifully in the context of the bull market of the last decade, as capital gains from the high grade portion of institutional portfolios have helped cover any losses from junk credits. Needless to say, this strategy may not work as well going forward, should the interest rate cycle ever turn.

Getting back to the American Dream deals, one approach would be to adopt what cynics would call a “yield-to-capitalized-interest” strategy. It is most applicable to project financings with start-up risk and usually works as follows: buy the deal and clip the coupon until capitalized interest runs out (usually about 3 years or so, to match the estimated construction period), sell out before the lofty financial projections for the project get a true reality test and then re-assess at that time based on the project’s actual performance. Better said than done, as always, since there is nothing harder in investments than to sell when everything still appears to be going well.

If you had to participate, one can make the case that the Wisconsin would be the better relative value, with potentially better liquidity due to its size and, more importantly, because PILOT payments are the equivalent of property tax payments and should enjoy the same municipal lien on assessed property (although they will be exposed to the vagaries of the NJSEA’s tax assessment practices and to fluctuations in the actual assessed value of the project itself). The only appealing features of the New Jersey issue would be the double tax-exempt coupon and the relatively shorter maturity, but those are offset by a much weaker security package based on incremental sales tax collections with imbedded state appropriation risk.

All other things equal, those State of Illinois GOs are looking better and better by the day.