MUNI WATCH: Colorado 'Dirt Bonds' Showing Signs Of Distress

--Deals are fastest-growing distressed muni debt, analyst says
--Such bonds rely on property taxes of district issuing debt
--Tax collections down as assessments catch up with the bust
--Distress in sector likely to be contained, underwriter says


The housing bubble popped more than four years ago, but its echoes are just being heard in Colorado.

Twelve real-estate development bonds issued in the state have become "distressed" in the past four months, according to Municipal Market Advisors, a research advisory firm. That is more than anywhere else during that period, including states more commonly associated with the bust, like Florida and California.

Such bonds, which frequently aren't rated by credit firms, are sold to pay for streets, sewers and other infrastructure in new commercial or residential developments, often before structures are built on the vacant land. Colloquially they are known as "dirt bonds." D.A. Davidson & Co., which underwrites metropolitan-district bond deals, estimates that Colorado districts sold $6 billion of these bonds between 2001 and 2010.

Dirt bonds in general are no stranger to distress, but most recent defaults and other problems followed the housing market crash, as developers abandoned projects for which issuers had already sold bonds. Some Colorado bonds are catching up with the crash only now because of the way the state assesses real estate and the limits some deals have on tax-rate increases.

Property in the state is reassessed over a two-year cycle, so 2011 valuations captured a lot of the recession's drop, according a report from the Colorado Legislative Council. A decline in valuations compels the metro districts that sold dirt bonds to increase tax rates; however, for most bonds sold within the last decade, tax rates have been capped to protect homeowners.

Some metro districts have had to dip into reserves or even default. Bonds most likely to show these signs of distress were sold just before the recession hitting in 2008, market participants say.

Murphy Creek Metropolitan District No. 3, for example, sold bonds in 2006 to support a residential golfing community near Denver. In 2010, it made only partial payments on the interest it owed, and it was unable to make a principal payment last December. (The district isn't in default because the terms of its bond allow it to pay delinquent sums later.)

The effect of Colorado's dirt bond delinquencies is difficult to gauge because most of the bonds rarely trade. Murphy Creek debt last traded in July 2010 at 51.75 cents on the dollar, with a yield of 13.3%, according to the Municipal Securities Rulemaking Board. A district representative wasn't immediately available for comment.

Murphy Creek isn't alone. Municipal Market Advisors has 29 Colorado development bonds worth about $520 million in its distressed-debt database. The 12 that dipped into reserves or defaulted in the past four months have a face value of about $134 million.

By comparison, the firm added only had two Florida dirt bonds in the last 12 months, managing director Matt Fabian said. The Colorado situation is "something to keep an eye on," he added.

People familiar with the market say the distress afflicting some Colorado dirt bonds is likely to be contained, in relation, say, to what's happened in Florida. About $5.5 billion of Florida dirt bonds--60% of the total of about $9.1 billion issued since 2005--have defaulted, said Richard Lehmann of Income Securities Advisor, a research firm.

Lehmann's statistics include issuers that drew on reserve funds to pay investors as well as those that didn't pay all they owed, so the figures tend to overstate investors' losses.

The good news for holders of Colorado dirt bonds is that their distress isn't likely to rise to Florida levels because real estate values haven't fallen as much, said Sam Sharp, managing director of public finance at D.A. Davidson. As of November, Miami home prices had fallen 51% from their 2006 peak, while Denver prices had slid 11%, according to S&P/Case-Shiller Home Price Indices.

Investors also are protected by clauses in some bonds that, for example, set aside some of the bond proceeds as security for the bondholder until the expected development occurs, or pledge prepaid district fees paid by the developer to bondholders.

John Miller, co-head of global fixed income at Nuveen Asset Management, said investors must be picky with dirt bonds, because underwriting standards and bondholder protections vary widely. His firm manages about $80 billion of muni assets, including dirt bonds in both Colorado and Florida.

Andrew Sanford, portfolio manager for ITG Fund II, a high-yield muni fund with $30 million in assets, said he prefers Florida dirt bonds because they're usually secured by a priority lien on the property. Colorado dirt bonds, by contrast, are secured mostly by property taxes, which makes the situation "out of your hands a little bit," he said.