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Cities’ pain is some investors’ gain.
With bond default rates and bankruptcies among city and state municipalities on the rise, vulture investors see an opportunity to realize double-digit returns — which are tax-exempt to boot.
“I see a lot more defaults coming,” said Jon Schotz, whose Santa Monica, Calif., firm, Saybrook Capital, is one of the pioneers in distressed muni investing, going back to the infamous Orange County bankruptcy in 1994.
Other firms ramping up in the market for distressed munis include Hamlin Capital Management and Fundamental Advisors, started in 2007 by Laurence Gottlieb, the former head of Citi’s distressed muni trading unit.
Fundamental recently hired Hector Negroni, the former head of Goldman Sach’s muni trading effort, to start a new fund.
Another new player is Spring Mountain Capital, which hired distressed pro Garey Fuqua to launch its distressed muni strategies group in January.
Last week’s decision by the California city of San Bernadino to seek bankruptcy as a way of solving its intractable financial problems is part of a growing wave of defaults and bankruptcies that used to be a drop in the bucket.
San Bernadino is the third US city to choose bankruptcy this year—a huge shift from the past. In the 41 years between 1970 and 2011, only five municipalities rated by Moody’s Investors Service filed for bankruptcy, and one of them filed in 2011.
The change is an ominous development for typical muni bondholders, most of whom are retail investors.
Buying distressed muni bonds is not for the fainthearted. Distressed debt investors buy the bonds at rock-bottom prices, and hold onto them through the restructuring, hoping the prices will rise. The average historical recovery rates for defaulted muni bonds is 65 percent compared to 45 percent for corporate senior unsecured bonds, according to data provided by Moody’s.
When cities file for bankruptcy, they have total control over the process, in contrast to a corporate bankruptcy, where creditors can propose an alternative plan. There is no guarantee that bondholders will get paid before other creditors, such as employees and their pension plans.
The dire straits of many municipalities are leading them to make harsh choices, which may force bondholders to share in the pain. Some cities “are already up against the wall,” said Moody’s managing director Anne Van Praagh. “They’re turning to bankruptcy to extract concessions from bondholders.”
For example, Stockton, Calif., the largest US city to file for bankruptcy, cut retiree health benefits to the bone, but it also suspended debt payments.
“Political risk is much tougher to assess,” said Schotz, who so far has not invested in any of the latest bankrupt munis.
Some distressed muni investors, like Spring Mountain’s Fuqua, prefer to invest in revenue bonds issued by hospitals and charter schools, saying these issues are small enough that he can have an “activist involvement and significant influence over any needed restructurings.”