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“When these bonds become distressed, selling them can be difficult given the lack of liquidity in the market for distressed bonds. That enables knowledgeable buyers the opportunity to strike a good deal” |
The municipal bond market is booming in the US. Municipalities and other tax-exempt borrowers sold a record $31 billion of municipal bonds in September, and the 2007 totals are expected to exceed $420 billion. The appeal of the municipal bond market is predominantly two-fold for investors. First, the Internal Revenue Service code looks favourably on bonds that fund projects to help a community grow or develop infrastructure. As a result, the returns on municipal bonds are tax-exempt. Second, it’s an inefficient market where there is inconsistent disclosure and more than 60,000 issuers with in excess of $2 trillion outstanding. So for those with expertise, the muni market can provide big opportunities.
Saybrook Capital sees the opportunities in distressed and defaulted munibonds. Institutional buyers tend to dominate the high-yield muni market. “Since they compete for yield, occasionally marginal projects are funded that don’t always capture the appropriate trade-off between risk and return,” says Jon Schotz, Saybrook co-founder and CIO, and co-portfolio manager of the firm’s Tax-Exempt Opportunity Funds. “In other words,” he says, “investors earn fixed-income returns while taking equity risk. When these bonds become distressed, selling them can be difficult given the lack of liquidity in the market for distressed bonds. That enables knowledgeable buyers the opportunity to strike a good deal.”
Saybrook Capital certainly benefits from experience. Before launching its first fund in 1999, the firm had been investing its own capital in defaulted munibonds, using its expertise in advising on municipal and corporate restructurings. The firm has served as financial adviser in some of the largest bankruptcies in history, including United Airlines, Orange County and Pacific Gas & Electric.
Schotz believes the market environment to be supportive of investment opportunities in distressed munibonds. “Since credit spreads began to widen in June, there have been a number of opportunities cropping up in the muni market,” he says.
Increasing problems with the US healthcare system also provide opportunities for Saybrook and its investors. Many hospitals are not being reimbursed at sufficiently high levels by the state and federal governments, and are being forced to close. The state of New Jersey is one of the worst affected. According to Gary Carter, CEO of the New Jersey Hospital Association, half of the state’s hospitals are losing money. Twenty-one hospitals have closed in New Jersey in the past 15 years, with two more recently announcing plans to shut down. And three hospitals filed for bankruptcy protection before the summer.
For Schotz, problems in the healthcare system provide opportunities. “It’s not just New Jersey. There are a number of states facing these issues – not only with their hospitals but also with nursing homes and the like. The opportunity for us lies in selecting the right bonds to buy.”
Consensus
Once Saybrook buys the bonds, the firm will attempt to figure out a consensual solution. That can range from providing additional capital for expansion to forbearing debt service until specified milestones are reached. This process takes time, so bonds are generally held for two to four years.
Similarly, the abrupt slowing of the real estate market in the US provides Saybrook with investment potential. Property developments are being abandoned before completion by developers as home sales dwindle and builders can no longer continue to build new houses in areas that are overbuilt. Schotz provides, as an example, Tern Bay, in southwestern Florida. The site was planned for nearly 1,800 homes but, as interest dried up, fewer than 70 were built, and many of those remain unsold. Lennar, the builder behind the project, has stated that it has no plans to continue building, and the golf course that attracted some customers in the local area shut in September. “Projects such as Tern Bay have debt outstanding that they will not be able to pay back within the timeframe required by the bonds,” says Schotz. “The most distressed level we have seen for these bonds is a yield of 6.85%, which does not adequately reflect the risk of default.” And he estimates billions more dollars will soon be hitting a similar wall, particularly in Florida, where real estate prices rose so quickly fuelled by easy mortgage money.
Saybrook has three Tax-Exempt Opportunity Funds that are structured like private equity funds. “Amidst a restructuring, you cannot tell what a bond is worth, so it doesn’t make sense to allow investors to leave mid-process. Structuring the fund in a private equity format enables us to get around the mark-to-market issue,” says Schotz.
Saybrook’s first fund is projected to earn annualized returns of 11% net of fees to investors, which is a taxable equivalent yield of 15%. Its second fund will return roughly 15% to investors, which is a taxable equivalent yield in the low 20s. Saybrook launched its largest fund in 2005; this raised $300 million from institutional and high-net-worth investors.
