While many banks get involved in tax-exempt loans or bond purchases, many overlook the much smaller but vitally important taxable market. While larger spreads can be achieved in the tax-exempt market, that market comes with the risk that the bank’s tax position could change. This could happen because of either a tax law (i.e., like just happened with tax reform) change or because the bank records a loss for a year, and it cannot take immediate advantage of the tax-exempt income. When factoring that risk in, combined with adjusting for liquidity risk, taxable loans to municipal entities become an attractive business line for a bank. In this article, we recap the market and discuss the opportunities for taxable bank loans.
Taxable municipal debt occurs when either the uses of the proceeds do not qualify for tax-exempt financing, or the entity isn’t able to issue tax-exempt financing due to a cap or legal structure with the financing. Similar to the tax-exempt market, the bulk of the maturities are between ten and 30 years with 20 years being the most common.
The bulk of this market is redevelopment, or where the municipality wants to provide some incentive to a targeted industry or project but cannot use its tax-exempt authority because of the purpose or lack of voter approval. For example, a municipality may try to attract a university or hospital and provide a partial guarantee of debt in addition to the issuance of taxable bonds. This taxable debt usually comes at a lower cost than the university or hospital could issue debt themselves in the corporate market. Healthcare, education, long-term care, consumer services, power generation, entertainment (mostly golf courses) and utilities make up the majority of the taxable municipal market.
At present, according to Bloomberg, there is over $411B of taxable debt outstanding. While the bulk of the market is bonds, some are loans. While we will be discussing how to turn bonds into loans later in the article, let’s first take a look at the total market.
While 56% of the market is “AA” rated, 19% is “A” rated which is the sweet spot for banks. 7% is “BBB,” the next best value for banks, while “BB” composes 1% and NR makes up another 1%. These spots, in order, are where banks usually play.
When it comes to pricing, spreads, of course, are correlated with the rating. “AA” rated debt is usually too competitive and too tight for banks to garner a suitable return. For example, a loan to an “AA” rated non-profit private water district is averaging a credit spread of +106 basis points (bps) over swaps compared to that same “A” rated entity that would go for +150 bps over swaps. Sample pricing of some more popular bank debt issues can be seen below.
From a credit standpoint, underwriting taxable municipal loans are similar to underwriting a mid-sized or large corporate entity. Many of these projects are largely non-profit and for-profit endeavors that have little or no municipal backing other than maybe a land or lease contribution and the issuance of taxable debt. These are often 501(c) (6) organizations. As such, these loans should be underwritten just as a C&I or commercial real estate loan would with a couple of exceptions.
All things being equal, taxable issues are a little riskier than their tax-exempt brethren because of the higher debt service cost and that there is no added incentive to remain current on the debt payments for fear of losing the tax-exempt status. This risk is partially offset because since the issue is already taxable, the bank enjoys a larger tax-equivalent spread and doesn’t have the full risk of tax bracket variability or the potential legal risk of a tax law change.
The reward for this type of business is substantial. For starters, these loans are often the first way to establish a relationship with a smaller municipality that can provide material deposits. Unlike larger municipalities that are often required to place their excess liquidity in state-run pools or have indexed rate requirements, these smaller entities may not be subject to that requirement and may place greater emphasis on the relationship.
Many of these entities don’t issue often enough or in large enough amounts to make obtaining a rating economically viable. As such, many of these projects have greater than 3x debt service coverage, have the profile of an “A”-rated entity but are priced like an unrated credit. This presents excellent arbitrage for the bank.
Further, the stability of the cash flows of many of these entities plus the low probability of default presents a solid risk profile for many banks. Cash flows for municipal and quasi-municipal issues tend to be more stable than their corporate counterparts. As a result, risk is often lower and the diversification benefits a bank heavy in commercial real estate.
Below is an example of one of the more risky types of taxable municipal credits. Despite lower than average debt service coverage (2x), this credit still has a low forward-looking 24 basis points expected loss rate. As can be seen below, this equates to almost an 18% risk-adjusted return on equity, priced at Libor + 1.75%.
In addition to being an attractive return, these taxable municipal credits have low correlations to the commercial real estate averaging between 17% and 55%. As real estate loans go down in value, entities like water, electric, healthcare, and education often hold relatively steady. This makes this a desirable diversification play for many banks.
Putting This Into Action
The key to gaining this business is to market directly to your local municipalities (good) and to your state’s financial advisors (better). Most public entities and their financial advisors understand bonds but not how bank loans work since their use is infrequent. As such, education is often needed so all parties can understand the process, potential timing, capabilities, and risks.
Banks may often find themselves where public securities are a foregone conclusion as maybe the borrower is too far along in the underwriting process or have authorization only for a public issue. In these cases, banks can negotiate to purchase the securities in whole and can negotiate their own potential terms. While a little higher cost for the issuer, one advantage here is that theoretically, the bank gets a much more liquid loan as they can sell the debt at any time.
Being able to provide longer maturities out to 20 years eliminates most all community bank competitors in the taxable municipal space. As a result, banks that want to focus on this niche can gain a low-risk borrower at attractive returns.
There are many reasons why a municipal or quasi-municipal entity needs to issue taxable debt in the form of a loan. The size, maturity, use of proceeds and many other reasons all place bank in an excellent position to be more flexible than the public markets and provide debt with lower transaction costs.
Submitted by Chris Nichols on August 22, 2018