‘Conduit’ municipal bonds allow private entities to tap into low-cost municipal bond financing. They account for about 20% of the market but about 70% of all defaults.

By Nathaniel Popper, Los Angeles Times
June 14, 2011

An often-ignored corner of the municipal bond market is causing outsize troubles for investors.

A spate of municipal bond defaults in recent months has included a $43-million issue that went to pay for a Hampton Inn in Boston, and $15 million in bonds that funded a commercial cargo facility at an Alaska airport.

These are not traditional municipal bonds used to finance sewers and schools. These debts are a form of financing known as conduit bonds. Conduits allow private entities to tap into low-cost municipal bond financing for projects that boost economic development. State or local governments are paid fees to issue the bonds on behalf of companies or nonprofits, which are responsible for repaying investors.

Conduits have grown roughly three times faster than the general municipal market over the last five years, according to data from Thomson Reuters, a New York data firm; $84 billion of these bonds were issued last year alone.

Investors don’t have to pay taxes on the interest from municipal bonds, enabling companies such as the Boston hotel developer to borrow money at lower interest rates than they could get on their own. Borrowers also don’t have to provide as much financial disclosure as they would if they went through the taxable corporate bond market.

And for cities and states, they get to encourage economic development, earn fees for their service and incur little risk if the bonds default.

But as the market has grown — and a wider variety of private companies have gotten access to tax-free financing — these bonds have begun attracting scrutiny.

Although conduits account for roughly 20% of all municipal bonds, they have been responsible for about 70% of all defaults in the municipal bond market in recent years, according to Income Securities Advisors, a Florida research firm. Over the last two years, the five municipal bond issuers with the most troubled bonds have all been conduit bond issuers, according to Municipal Market Advisors, a Concord, Mass., research firm.

“It’s the conduit bonds that are really at the root of the default problem,” said Richard Lehmann, the founder and president of Income Securities Advisors Inc. Lehmann’s firm estimates that $35.7 billion worth of conduit bonds have defaulted since 1980, and many of those have returned little to investors.

The bonds have also been costly for the federal government, which is expected to lose out on about $10 billion in tax revenue this year because of the exemption, according to White House statistics. Beneficiaries of this low-cost financing have included United Airlines and General Motors Co., companies that could easily borrow in the corporate bond market.

“A lot of these are corporate bonds disguised as municipal bonds,” said Michael Lissack, a former municipal investment banker at Smith Barney who is now a critic of the industry. “How is this a good use of our tax expenditures? I would prefer to use that money seeing that kids get vaccinated or learn to read.”

These defaults are also having a ripple effect on the broader municipal market, which has been under siege after financial analyst Meredith Whitney predicted hundreds of defaults on muni bonds. That statement led to a broad sell-off in the muni market.

Frank Hoadley, who is in charge of selling traditional municipal bonds for the state of Wisconsin, said that the riskiness of conduit bonds has driven up borrowing costs for cities and states. He said Wisconsin paid $4 million more in annual interest than it would otherwise have had to on new bonds issued in January because of investor fears about the municipal market.

“Government issuers like Wisconsin are swept up in the smear that is tarnishing the whole municipal market because of conduit borrower problems,” said Hoadley, Wisconsin’s capital finance director.

Although average investors might not understand the difference between conduits and traditional municipal bonds, the difference is quite marked. Conventional munis make interest payments from dedicated streams of revenue such as taxes, fees and tolls. In contrast, conduit bonds are generally only as good as the projects they fund. When the hotel in Boston goes under, so does the bond.

Not all conduit bonds are risky. Some public issuers force corporate or nonprofit borrowers to pass rigorous credit tests. Some of the largest state-run issuers, such as the California Health Facilities Financing Authority, have seen few of their conduit bonds default.

But a series of recent defaults in conduits, particularly those issued for low-income housing, healthcare facilities and industrial development projects, has caught the attention of regulators.

“The market which used to be mom and apple pie now doesn’t look like mom and apple pie anymore when you get further and further away from a traditional public purpose,” said Lynnette Kelly Hotchkiss, the executive director of the Municipal Securities Rulemaking Board, the congressionally appointed regulator for the municipal bond industry. “That has the potential to ruin it for everybody.”

Hotchkiss is not the only regulator taking a closer look at the market.

On Wednesday, the Internal Revenue Service, which defines what projects can qualify for conduit financing, is set to release a report prepared by its independent advisory committee. The report will discuss how little attention has been given to oversight of conduit bond issuers.

“There’s never been a considered examination of what these entities are actually supposed to be doing,” said Michael Bailey, a Chicago tax lawyer on the IRS committee.

The Securities and Exchange Commission is considering whether conduit borrowers should be required to provide more information to investors.

Conduits, or private activity bonds, have been around in various forms for decades. Still, most aren’t graded by credit rating companies, and even basic data, such as information on defaults, are hard to come by.

Local governments are supposed to provide oversight, but they apply widely differing standards on what projects qualify for conduit financing. Moreover, because governments aren’t financially liable for the bonds, they have an incentive to issue conduits to earn fee income, regardless of the risk to investors.

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