Top muni manager says dirt bonds dirt cheap

Nuveen's Miller snapping up debt tied to land projects; fund up 21% in 2012

Jan 23, 2013 @ 3:39 pm (Updated 4:00 pm) EST

dirt bonds
This started out as a lot

John Miller at Nuveen Asset Management LLC, who beat all his U.S. municipal bond-fund peers in 2012, is betting a rebounding housing market will deliver the biggest gains again in the year ahead.

Miller, 45, has been buying debt tied to homebuilding and land-backed securities called dirt bonds for the $9 billion Nuveen High Yield Municipal Bond Fund (NHMRX), which earned 21.2 percent last year. The gain beat all open-end, national muni funds that are at least three years old and geared toward institutional investors, data compiled by Bloomberg show.

The fund invests in securities rated BBB+, three steps above junk, and lower. It's betting on the riskiest part of the $3.7 trillion muni market -- land-secured debt accounts for almost half of muni issues in default. Miller is doing this as builders last year broke ground on the most houses since 2008 and home prices rose the most in more than two years.

“We are still buying areas that are benefitting from the improvement in real-estate markets,” said Miller, who helps manage $86.5 billion of munis as co-head of fixed-income in Chicago. “So we're still buying tax-allocation, property-tax backed issues.”

Risk Search

Investors sought riskier debt in 2012 as a rally in the municipal market drove yields on local borrowings to a 47-year low.

Munis earned 7.3 percent last year, Bank of America Merrill Lynch data show. Pioneer High Income Municipal Fund (HIMYX), run by Tim Pynchon, was second behind Nuveen's portfolio, returning 21.1 percent. Lord Abbett High Yield Municipal Bond Fund (HYMFX), managed by Daniel Solender, placed third, gaining 18.1 percent.

For the Nuveen fund, last year followed a 2011 performance that failed to place it in the top 10 muni portfolios. Even so, its 11.6 percent 2011 return eclipsed the market's 11.2 percent advance.

The 2012 gain was fueled by a 20 percent allocation to land-backed debt, Miller said. Such bonds comprise about 7.4 percent of the S&P Municipal Bond High Yield Index. The tax- exempt securities finance real-estate projects, with the developer paying special assessments to repay the bonds.

The real-estate market is showing signs of gaining momentum. Builders started new homes at an annual rate of 954,000 in December, the highest since June 2008, according to Commerce Department data. Housing prices rose 4.3 percent in October from a year earlier, the biggest advance since May 2010, according to the S&P/Case-Shiller Composite-20 City Home Price Index.

Drywall Backing

Nuveen's eighth-biggest holding, revenue bonds backed by USG Corp., the nation's largest distributor of drywall, earned about 27 percent in the past 12 months, according to data compiled by Bloomberg based on trading levels and assuming no reinvestment yield. The debt, which financed a solid-waste facility in Pennsylvania, is state tax-exempt and subject to the alternative-minimum tax at the federal level.

A Florida dirt-bond offer that Nuveen held as of Dec. 31 gained 26.9 percent last year through Dec. 5, based on trading prices and assuming no reinvestment yield.

“We were able to take advantage of credit-spread narrowing in the sectors that actually did the best,” Miller said.

Restructuring Phase

Still, land-secured borrowings are riskier than most munis.

Bondholders aren't receiving principal and interest payments on about $11 billion of muni debt, from 385 defaults, as of Jan. 16, according to Concord, Massachusetts-based Municipal Market Advisors. Land-secured debt, including dirt bonds, account for 188 of those filings, the most by number.

Holders of dirt bonds will need to take a loss on these deals to restructure the debt, said Richard Lehmann, publisher of the Distressed Debt Securities Newsletter in Miami Lakes, Florida.

The segment's fiscal strains are evident in the Tampa, Florida, region, which has 50 community-development projects in default, he said.

“How do you sell any lots in that area when you have 50 distressed properties that have excessive tax allocations on them, and they're all trying to bid for a very finite number of new home buyers?” Lehmann said.

Debt backed by tobacco-settlement payments from cigarette makers, as well as airline bonds, health-care securities and industrial-development borrowings also helped fuel gains in 2012, said Miller and Pynchon, 53, who helps manage $3 billion of munis at Pioneer Investment Management Inc. in Boston.

Smoking Return

Tobacco bonds earned about 32 percent tax-free in 2012, beating all classes of munis, according to Barclays Plc data.

The top five muni funds in 2012 were high-yield portfolios.

Such funds may outperform again this year as the extra yield that investors demand on lower-rated securities has more room to shrink, Pynchon said.

The yield spread on BBB munis due in 30 years over top- rated tax-exempts set a four-year low of 1.66 percentage points in October. Still, that gap is wider than the 10-year average of about 1.45 percentage points, Bloomberg data show.

“We're certainly not going to see a year like we saw in 2012,” Pynchon said. “But I think there's still some value left and there are enough inefficiencies in our market so that the savvy high-yield investor is going to be able to realize some good value.”

<-i>--Bloomberg News--

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