Today and Monday, individual investors have a unique opportunity to “benefit” from the greatest bond bubble in history, even before institutional investors get to jump in, and buy sewer bonds – yup, that’s where they belong – issued by a county that landed in bankruptcy court because it defaulted on its prior sewer bonds. The money will go to the existing bondholders who’ll get a fashionable haircut as part of the deal – a deal made in bond-bubble heaven.
Jefferson County, which includes Alabama’s largest city, Birmingham, filed for Chapter 9 bankruptcy protection in 2011 when it defaulted on $3.1 billion in sewer bonds. At the time, it was the largest municipal bankruptcy. That record was crushed when Detroit filed in July.
In the olden days before the Fed repressed interest rates to near zero, back when it was a little harder for banks to fleece depositors on a daily basis, and when risk still had a price – a steep price – and when yield investors were less desperate, this deal would have been DOA.
No conservative investor – and that’s what muni buyers are – would have lent to a municipality that had just ripped off its existing bondholders. There would have been a penalty for its reckless financial behavior. And it would have been exacted by the market: no more new debt, not for a long time, or only at a prohibitive cost, with yields deeply into the double digits.
But now yield investors are desperate, driven to the edge of sanity by the Fed, their patience wrung out of them by years of QE, and in their search for yield, they’re turning over stones, and whatever squiggly toxic malodorous thing they see there, it entices them, and they hold their nose and take the risk, any kind of risk, and pick it up, hoping for a little bit of income above the rate of inflation, and they’re so desperate that they even buy this Jefferson County sewer debt.
$1.8 billion! It matures in 40 years, a horizon beyond investor imagination. All sorts of things are likely to happen before 2053, including major bouts of inflation which would wipe out much of the value of the bonds, or more problems in the county leading to another bankruptcy, and another haircut. How likely is that? Just ask the current bondholders.
This debt will be sold in two tranches, Bloomberg reported, citing anonymous sources because the pricing won’t be final until next week: $500 million in senior debt at a yield of 5.75%, insured by Assured Guaranty Municipal Corp., and $1.3 billion in subordinated debt at a yield of 6.5%. That $1.8 billion would pay off in part the $3.1 billion in defaulted bonds. Existing bondholders would eat about $1.4 billion. They’d bought these sewer bonds as a safe tax-advantaged if low-yield investment. Now they’re losing 46% of their principal.
As part of the deal, sewer rates are going to rise, every year for the next four years, by 7.9%! And from then on by 3.5% a year through 2053. These rate increases are supposed to help pay for these bonds.
Alas, efforts to raise sewer rates to keep the county from defaulting on the bonds triggered a series of lawsuits before, two of which are now included in the bankruptcy and may be discharged as part of the adjustment. Sewer-rate increases to pay bondholders are not welcome in Jefferson County. And there are no guarantees that it will welcome them in the future.
Nevertheless, in a fit of drunken enthusiasm, or stupor, Standard & Poor’s slapped a rating of AA on the insured bonds, with an underlying rating of BBB. And it honored the junior bonds with a rating of BBB-. Investment grade! Nothing can go wrong. Your conservative bond mutual fund that insists on at least one investment-grade rating will be standing in line to load up to catch some yield.
Moody’s Investors Service mercifully refrained from the temptation to kick these sewer bonds with a rating, but still warned that they had “noninvestment grade characteristics.”
Fitch considered them junk. It doused them with a rating of BB+ and BB respectively due to a “significant concern” that the projected cash-flow shortfall starting in 2024 would hit the sewer system’s capital needs. It fretted about high debt levels, back-loaded debt payments, and other issues, such as the sharply rising sewer rates, that “could spark increased political concerns, litigation, and elasticity in usage, any of which might erode actual financial results.”
But the success of the bond sale would teach the county and other troubled municipalities across the country something important: there is no longer a penalty for bankruptcy.
There used to be a fear that once a municipality had stiffed bondholders in bankruptcy court, it would have trouble accessing the credit market again for a while, that it would be frozen out by investors who recognized the risk of reckless behavior and wanted to be compensated for it. But now, instead of forcing the municipality to get its financial house in order, bankruptcy offers an efficient method to live beyond your means and do dubious deals, then slough off that debt and get more money from new bondholders without even a pause. And start all over again.
Other cities are already trying it. Vallejo, a Bay Area city of 115,000, emerged from bankruptcy two years ago and is still struggling with soaring pension costs that had been left untouched. Yet, about a month ago, it was able to sell some bonds that will keep it afloat a while longer. And Stockton, another California city that went bankrupt, was able to borrow $55 million in new money to pay off some old water debt.
These pale in comparison to Jefferson County’s $1.8 billion in bonds, sold while still in bankruptcy. And then of course, there will be Detroit…. The discipline of the market has been squashed. One of the Fed’s most admirable accomplishments. And one of the many hallmarks of the greatest bond bubble in history.
But what will it do to the many deeply troubled municipalities? The lack of penalty and the availability of new money will encourage them to file for bankruptcy to wipe off in one fell swoop the sins of the past – only to commit more sins with new money, even more freely! More and more muni investors will be sacrificed on the altar of the Fed’s policies. And the Jefferson County bond deal might just be what it takes to open the floodgates.