Wednesday, 10 February 2016
Last updated 13 min ago
Oct 24 2007 | 11:28am ET
By Jon Schotz
A number of years ago I found myself on a remote California desert road driving past a worm farm. The land nearby was the target for municipal bonds designated to raise capital for a new housing community, but the bonds had missed a payment. I was there to determine the value of the bonds.
As I surveyed the area, the underlying problem was very clear: there were few employers of consequence for miles. It was clear to me why this bond defaulted. The question was how many pennies on the dollar was it worth.
This is a common experience for an investor in distressed and defaulted municipal bonds. Even at the investment-grade level, the municipal bond market can be opaque and inefficient. Once you move further down the credit spectrum to the distressed bond market, there’s so little current information that you have to do your due diligence the old fashioned way: driving to the site, poking around and asking lots of questions. And that’s just the beginning.
Below A Tranquil Surface Lies An Underbelly
Let’s start with some high-level statistics: There are in the neighborhood of 60,000 municipal bond issuers (such as townships, cities, states, etc.), and more than 2 million individual bonds currently outstanding. The bonds are issued to fund everything from hospitals to highways and airports to multifamily housing projects. The total value of all outstanding municipal bonds is more than $2.2 trillion. There are more than 2,000 muni dealers, but no centralized exchange. Average daily volume in 2006 was estimated at more than $20 billion, but many bonds sit untraded for months or years at a time since investors are often in for the long haul. Municipal bonds have varying levels of tax advantages, which tend to attract high-net worth individuals and family offices looking to ease their tax burdens.
Like equities and other debt securities, there are regulations regarding disclosure for municipal bonds. However, what is actually disclosed differs from municipality to municipality. In other words, timely, audited information is a rare commodity. Making the situation even more difficult is inconsistent documentation. For example, what is labeled as one type of security may, on closer inspection, turn out to be a completely different product.
These conditions make detailed research an absolute necessity, but because of the number of securities and the inconsistent reporting, there’s not much reliable independent information available to help investors with their decision-making. Research houses don’t focus on smaller municipal credits, and the information they do provide usually lags the market instead of leading it. Investors who want to get into the municipal bond market are often left to do their own research.
Despite these harsh realities, municipal bonds are still perceived as “safe” investments. They generate modest pre-tax returns, but their tax advantages often bring them higher net yields than other fixed-income investments, particularly for high-net-worth individuals. Because of their relative safety and tax advantages, investors flock to municipal bonds.
When they do run into trouble, however, municipal bonds are difficult to value and sell, and the market becomes shadowy. Getting a bid on a defaulted bond with normal settlement terms is nearly impossible.
Hitching Your Wagon
For many people, however, particularly those in higher tax brackets, the opportunities available in the distressed municipal bond market can outweigh the potential peril. For them, the most important decision they need to make is how to enter the market. As with all portfolio investments, choosing a manager is key, and in the murky end of an already opaque market, the task of selecting a manager is even more difficult.
Solid experience is important for all investment managers, but in this market it’s critical. With very little reliable information to work from, distressed muni investment managers need well-honed instincts, an ability to know what questions to ask and time-tested pricing models.
Look for a manager who has solid connections with the dealer community, mutual funds and insurance companies. Being able to call both a seller and a dealer directly gives a manager access to information and increases the likelihood of completing transactions. Also, if managers have solid relationships, this means that parties are more likely to call the manager when they know of new distressed assets.
The distressed end of the market, because of the lack of liquidity, requires a longer-range investment horizon. As such, a private equity vehicle that requires a capital lockup of several years will typically make the most sense.
As the example of the deserted land around the worm farm shows, a little extra effort during the due diligence process can go a long way. In fact, more than many other asset classes, distressed municipal bonds require significant elbow grease throughout the life of the investment. Look for managers who are dedicated enough to roll up their sleeves and really dig for information and who are comfortable with the restructuring and distressed process.
Finally, look for an advisor with the proper market perspective. Distressed bonds do not exist in a vacuum, so it’s important to understand the broader economic climate. A skilled investor will take a top-down approach that focuses on overall economic factors, regional economics and sector dynamics. At the same time, the manager must also know how to analyze a credit from the bottom up. Both perspectives, and the ability to overlay them to reach a full understanding, are essential to a fund’s success.
Jon Schotz is co-founding partner and chief investment officer of Saybrook Capital, an investment management firm based in Santa Monica, CA.