October 11, 2016 / 11:01 AM / in 2 years

RPT-With soaring demand come weaker assurances for US municipal investors

(Repeats for wider distribution)
    By Hilary Russ
    NEW YORK, Oct 11 (Reuters) - In July, investors gobbled up
$1 billion of bonds from a financially-strapped Catholic
hospital system in Illinois called Presence Health Network, even
though it offered few contractual guarantees debt buyers
typically require.
    The deal, rated just above junk status, is emblematic of a
fever that has swept the $3.7 trillion U.S. municipal bond
market: yield-chasing investors not only piling into riskier
debt, but also increasingly willing to accept less protection in
the event of a default.
    Some portfolio managers say it has been a decade since they
have seen such a strong seller's market.
    "It's reminiscent of right before the Great Recession, where
there was a long period where high-yield rates were low and
demand was high," said William Black, senior portfolio manager
for the City National Rochdale Municipal High Income Fund.
    Low and negative sovereign interest rates have contributed
to a scramble for relatively higher yielding U.S. municipal
debt. Foreign buyers now hold more muni bonds than ever, U.S.
Federal Reserve data show.
    Overall, investors have poured nearly $10 billion into
high-yield municipal bond funds so far this year, according to
data from Lipper, a Thomson Reuters unit. That is more than any
other full year in nearly the last quarter century except 2006,
which had $10.1 billion of inflows. (Graphic: tmsnrt.rs/2dylqFl)
    Taking advantage of the seemingly insatiable demand, some
borrowers are offering weaker or fewer guarantees, so-called
covenants, such as debt reserve funds and debt service coverage
    Because they are based on many factors, credit ratings alone
may not reflect the quality of covenants, so some investors may
be taking on greater risks than they realize. 
    Such "covenant light" bonds were harder to offload after the
market tumbled in late 2008, while investors who held them saw
valuations swing wildly because of infrequent trading and huge
price gaps, analysts said.
    "Some funds got just clubbed. That was frankly very
traumatic for a lot of investors, and fund managers too," said
Joseph Krist, partner at the Brooklyn-based public finance
consulting firm Court Street Group.
    In a default, workouts are harder. Covenant light
bondholders have fewer tools to intervene, for example by
requiring issuers to hire turnaround professionals or take other
corrective action earlier. They also risk deeper losses in
bankruptcy than those with greater protection.   
    Sectors such as healthcare, charter schools, and senior
living facilities tend to be more prevalent covenant light
issuers, in part because they may struggle more to generate
consistent operating margins.
    Hospitals and charter schools issued 44 percent and 76
percent more debt by par amount so far this year, respectively,
compared with 2015, Thomson Reuters data show. Senior living
facility issuance rose 6 percent.
    They come in other sectors too. The city of San Antonio,
Texas, sold AA-rated junior lien water system bonds on Thursday
without a reserve fund - a fact disclosed in the title of the
bond documents.
    But many covenant light deals are unrated or speculative
grade. Issuers have sold more than 400 percent more bonds rated
junk at BB and BB- by S&P Global Ratings so far this year than
last year, Thomson Reuters data show. 
    One such example is Summit Academy North, a junk-rated
Michigan charter school that missed deadlines for annual
financial data in four of the last five fiscal years, according
to bond disclosures.
    Summit sold $22.5 million of refunding bonds on Aug. 31 with
a cash on hand liquidity threshold of just 30 days, a very low
level for the sector. 
    Even so, the top yield was just 4.75 percent on 2035 bonds -
a rate that an investment-grade borrower would have likely
offered only a couple of years ago.
    "I cannot believe some of the deals that are getting done in
the muni market right now - without a mortgage, low debt service
reserve fund," Mark Paris, head of municipal portfolio
management at fund manager Invesco, said at a recent event.
    Some funds say they have little choice but accept fewer
safeguards in order to put clients' cash to work.
    "Money is coming in to the point where people have to buy
something," said one market professional who declined to be
    Institutional investors have pushed back by demanding
greater liquidity covenants, said Mark Taylor, a portfolio
manager and head of high-yield research at Alpine Woods Capital
    By September, he had a stack of rejected deals in his office
that was four-feet tall, Taylor said. Nonetheless, the deals he
has turned down are getting picked up by others.
    "There is a plethora of deals coming to market that people
probably would have rejected nine months ago." 

 (Reporting by Hilary Russ; Editing by Daniel Bases and Tomasz
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