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Chasing Yields, Muni Buyers Sign Away Safeguards Against Default

When Mount St. Mary’s University, a small Catholic college, borrowed money a decade ago to build and renovate dorms at its rural Maryland campus, it pledged a 179-bed residence hall as collateral, leaving investors with an asset they could seize if it defaulted.

In December, it refinanced the debt without extending bondholders that security. Lenders didn’t mind, placing nine to 12 times as many orders for $56.6 million of junk-rated bonds than were available, according to William Davies, the university’s chief financial officer.

The demand for higher-yielding debt during the decade-long era of low interest rates has allowed hospitals, schools and other borrowers in the $3.8 trillion municipal-bond market to jettison some of the protections they previously provided to investors. Even now, amid growing speculation about rising interest rates, a steady flood of cash has pushed risk premiums to their lowest level since the financial crisis.

High-yield municipal-bond funds have drawn in $23 billion in the last four years, about a quarter of inflows into state and local bond funds over that time, according to Lipper U.S. Fund Flows data. That has helped drive spreads over top-rated bonds to 2.92 percentage points by Feb. 12, down by about two-percentage points from two years ago.

“Borrowers have had very strong leverage over lenders for three years," said Jim Murphy, who oversees T. Rowe Price Group Inc.’s $5.5 billion Tax-Free High Yield Fund.

In addition to forgoing mortgage pledges, borrowers are selling bonds without reserve funds they can tap if they don’t have enough cash to service debt. Early warning mechanisms, such as rate covenants, which require borrowers to charge enough fees to pay debt service, are often weaker and remedies can be more limited than they had been, according to Municipal Market Analytics.

That will likely cause an increase in defaults -- which are extremely rare -- if the economy weakens, said Matt Fabian, a partner at MMA. 

“The more bonds done without a reserve fund or without a mortgage or with minimal coverage, the more likely they are to transition directly to default from under stress," he said.

Sales by the riskiest segments of the municipal market, which includes hospitals, charter schools and retirement facilities, has risen to 16 percent of issuance from 11 percent in 2014, according to the firm. Before the financial crisis, in 2007, such sectors made up about a quarter of municipal bond sales, according to MMA.

Tim Holler