Finding 'Diamonds' in the Dirt

By: James A. Klotz
President

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As investors know, the credit crisis that unfolded in 2008 wreaked havoc with virtually every asset class. Municipal bonds were no exception.
 
Although the lion’s share of municipal bonds continued to pay a steady stream of tax-free income, their market values were bludgeoned by forced selling from hedge funds, leveraged bond funds and other troubled institutional investors.

Fortunately, in the first two months of 2009, a good portion of the price declines in the high-grade sector of the market has been recouped. However, another market segment, Community Development District bonds, were also unfairly punished, but they have not kept pace with the recent rise in prices and merit serious consideration from muni investors seeking hidden value.

Also called “dirt bonds” by muni traders, the name does not conjure up the most appealing image, but with a little homework, investors have the opportunity to uncover “diamonds” in the dirt.
 
They are termed dirt bonds because their proceeds pay for the infrastructure on raw land in preparation for development. (Until the land is ready and homes are built, the developer is responsible for the interest payments on the bonds.)
 
Once the homes are built, a special assessment fee is automatically added to the homeowner’s property tax bill, which is on parity with the property taxes and remains in place until all interest and principal has been repaid to the bondholders.

Now for the homework
 
Due to the disruption in the housing market, several of the dirt bonds issued in the last few years have remained just that . . . dirt.
 
If there are no houses, there are no special assessments. This poses a potential problem for bondholders.

Our research

We focus on bond issues in which the communities are fully built out because many of these bonds were “lost in the shuffle” and can represent exceptional value.
 
In the past, most dirt bonds were issued as non-rated securities and would be privately placed in large institutions where they would be held to maturity. During the past year, as part of their deleveraging effort, banks were forced to sell large quantities of these bonds, severely depressing the market for these securities.
 
At FMSbonds, we saw this as a unique opportunity for our clients to participate in a market that had previously been the exclusive domain of institutional investors.
 
We asked our Chief Credit Analyst, Dr. Jay Abrams, to initiate an extensive research program on these credits to enable us to compile a list of recommended issues of stable communities that are sufficiently built out.

The yield advantage

Today, yields on dirt bonds range from approximately 6.50% for “A” rated bonds to 7.50% or more for non-rated bonds. The majority of these bonds also contain mandatory sinking funds that regularly produce reinvestable proceeds. If the bonds are purchased at a discount, these sinking funds produce yields that far exceed their yield to maturity.
 
We see this as an excellent opportunity for investors to increase the tax-free cash flow of their portfolios with bonds that possess many of the positive credit characteristics associated with general obligation bonds.
 
If you would like an in-depth credit analysis of any specific CDD bond we are offering, please contact your FMSbonds representative or the e-desk at 800-FMSbonds (367-2663). 

For a better understanding of the Community Development District bonds in general, please click here.

2/26/2009