Back in February, it was pointed out that the tiny city of Lamar (in Colorado) was about to make a very foolish move regarding a debt.
To recap: In 1979, six Colorado municipalities created the Arkansas River Power Authority (ARPA), which would provide electricity to its members. In 2004, ARPA launched the Lamar Repowering Project (LRP), an effort to convert an existing power plant from nuclear power to coal. Cost overruns and engineering mishaps resulted in a boiler with substandard emissions that could not be replaced, and the plant was shut down after an environmental group's lawsuit.
The LRP was funded by a municipal bond issuance on behalf of ARPA's six member cities, and the six municipalities are required to repay the debt with interest. Yet while the other five cities all bit the bullet and agreed on repayment, Lamar filed suit to avoid having to pay back its share of the debt or interest.
Settlement Key: Refinancing
However, Lamar finally did the smart thing, and accepted a mediated settlement deal. The key portion of this settlement is that the ARPA debt will be refinanced, with debt service being cut from the 5 - 6% range to the 3-4% range. This refinancing is absolutely critical, and a central aspect of the settlement.
Remember - the entire concept of an infrastructure bond is that the debt is used to upgrade or fix some piece of infrastructure that generates revenue. In this case, the revenue is supposed to come from the utility's customers. These kind of revenue-secured bonds are generally considered to have a relative degree of safety. People need electricity, they will therefore pay for electricity, and therefore there will be cash flow. That's why these bonds were issued in the 5-6% interest rate range. It's hard to believe, but at the time they were issued, that 5-6% rate was substantially below the Prime Rate - which was 7.5 - 8%. The bonds are considered so safe that they were thus issued at a very favorable below-Prime interest rate.
Were this a matter of a municipal default, like Puerto Rico, then there would be additional risk to bondholders. Additional risk equates to higher interest rates, not lower ones. Default isn't the problem with ARPA bonds. The issue was the desired plant never went online. Thus, a refinancing of the bonds during a period where the Prime Rate is only 4.25% presents a golden opportunity - one that actually can turn lemons into lemonade.
ARPA issued $146 million in bonds. Let's take 6% as the average interest rate on this debt, which amounts to about $8.76 million in interest paid every year. This debt service is paid from the electricity rates charged to the utility's customers. If the debt is refinanced down to 3%, then debt service is cut in half - to about $4.38 million per year - and therefore those savings can also be passed on to utility customers.
This is win-win all around.
So who's complaining?
The La Junta City Council Balks
However, another ARPA municipality. the La Junta City Council, voted 6 - 1 against the settlement.
The deal would also have ARPA pay Lamar $1 million up front, and $400,000 each year for 26 years. This is to compensate Lamar for the losses it endured, since its plant was the one chosen for conversion, and its failure left it as the only municipality to not have a plant of its own. Lamar also got this money because the other five municipalities were compensated by the engineering firm that messed up the project.
The La Junta City Council Minutes offers a frustratingly political explanation or the settlement rejection. On page 13, the Mayor says, "I have a problem with offering Lamar $11.5 million on a forty-year-old power plant that was running at 30% or so efficiency. It's time life was pretty much done". An ARPA rep tells him that experts confirmed the plant's value, but the Mayor simply says it is too highly valued, without explaining why, or offering any counterargument.
The rejection makes no sense, and worse, it threatens to destroy the critical bond refinancing.
The Minutes, on page 11, even say, "APRA is concurrently seeking to refund or refinance the bonds issued for…the LRP…which is expected to more than offset the anticipated payments to Lamar under the settlement. However, such refunding or refinancing is unlikely to be possible unless the litigation is promptly dismissed" - which Lamar agreed to do.
By spiking the settlement, the litigation returns, the case moves to trial, and the chance to refinance will be lost. Interest rates are rising. The litigation and appeals will take years and by then, the Prime Rate will be much higher.
The La Junta city council is making a foolish mistake. Under the settlement, La Junta comes out slightly ahead. By rejecting the settlement, the case goes to trial. If ARPA loses, it will be on the hook for 20% of the debt as opposed to 16.7% under the settlement, since Lamar would no longer be liable, having successfully extricated itself from the co-op. Even worse, La Junta would be paying the higher interest rate since refinancing would not happen. Even if ARPA wins, La Junta still loses the chance to refinance at lower rates, and will pay more in debt service.
Why Does This Matter?
Why is this happening? The most likely explanation is that, with a population of only 7,000, if the City Council can reduce the payment to Lamar by even half a million dollars spread among the other municipalities, that means another $100,000 for the La Junta bank account - not insignificant given the city's small size.
In other words, politics and money trump. This is not only short-sighted and arguably greedy, but it subordinates the much larger municipal debt picture. The City Council needs to accept this settlement for its own good, the good of its citizens, and for the entire region to get past this disaster.
Why is this so important? Many investors mistakenly dismiss this tiny municipal debt battle as somehow being insignificant. Yet this is how contagions begin. There is always a zero patient, and this is a prime candidate.
Infrastructure bonds exist all over the muni bond market. With the rise of environmental lobbies, it is becoming easier for said lobbies to de-rail muni projects financed by bonds. Once money has been spent from a bond issue, if a project gets shut down by environmental (or other) groups seeking to politicize matters, you can bet the borrowers are going to look to the ARPA situation for guidance. They might choose to walk away or sue as Lamar initially did, or balk at settlements if it means someone else - such as a bond insurer - ends up holding the bag.
Bond buyers and insurers will then look askance at any similar borrower, and boost interest rates on debt to compensate for the additional risk.
Not only that, lenders may be reluctant to refinance, if they see the ARPA situation, and realize that a reduction of debt service is not a good idea amidst increased risk.
As discussed in the previous linked article: "This could easily create a cascade of selling across the entire $4 trillion municipal bond market. If Lamar got this far with its case and, especially if it should win, then it could occur with any municipality at any time. Imagine one municipality after another simply deciding it wasn't going to repay its debts because of the slightest adverse occurrence. Muni bonds are favored by retired investors for their perceived safety and tax-free yields. The last thing the country needs is for one tiny city to muck up the retirement plan of millions of retired Americans."
There's an additional problem. Politics are hindering resolution with the Puerto Rico debt crisis. Politics is hindering the ARPA situation. Other municipalities, including states like Illinois and New York, are in big trouble financially. They are surely looking at these situations for guidance on how to renege on bondholders. There are more defaults coming, and the more cases in which borrowers dishonor their obligations, the more likely for a long, slow, muni bond contagion that results in a massive sell-off.
Opportunity in the Bonds
As for those holding bonds in ARPA, let's look at what's out there and what might be affected, because there may also be opportunity here.
- Arkansas River Power Authority Colorado Power Revenue Improvement (CUSIP 041036BX1): 5.875% coupon. Maturity: 2026. Issued at 118.647. Current price:114.238.
- Arkansas River Power Authority Colorado Power Revenue Improvement (CUSIP 041036BY9): 5.25% coupon. Maturity: 2032. Issued at 112.235. Current price: 100.
- Arkansas River Power Authority Colorado Power Revenue Improvement (CUSIP 041036BZ6): 5.25% coupon. Maturity: 2040. Issued at 112.519. Current price: 100.205.
- Arkansas River Power Authority Colorado Power Revenue Improvement (CUSIP 041036CL6): 5.25% coupon. Maturity: 2043. Issued at 101.587. Current price: 100.578.
One can't predict the future, but here is an educated prediction on what will occur. If La Junta is trying to squeeze Lamar to accept a little less money, which would mean a lot more to La Junta than the hefty costs that a trial would cost Lamar, then there will be a settlement. After all, Lamar may or may not win the trial, but it will certainly spend millions to litigate. If it agrees to take a million or two less, a portion of that money stays with La Junta.
In that case, the 2032 and 2040 maturities are trading at a 12% discount. There could be a value play there. The downside for the 2040 bonds is fairly small. The lowest they traded at was 96.633 last December. The 2032 bonds never got below 94.3 (last March), and that was but one trade in a $7,000 block. So there seems to be some decent risk/reward possibilities here.
The other two bonds don't seem to offer as much, trading at such small discounts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.