#15 – Kjerstin Hatch: Muni Bond Market

0:06Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry investment and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, one of the nation's leading investment advisory firms. Learn more about our show at insightfulinvestor.org.

0:43I'm delighted to have Kirsten Hatch with me today on the podcast. Thanks for being here, Kirsten. My pleasure. Thank you for having me. Kirsten is the founder and managing principal of Lapis Advisors, which she launched in 2009 to focus on special situation securities within the world of municipal bonds, which we're going to spend some time talking about. But before we jump into that universe, would you just share your background and how you got started in the investment business? Absolutely. When quite young, in retrospect, I started in real estate. I worked for a firm that aggregated little pieces of real estate together that were fractionally owned.

1:30These are by and large partnerships that were syndicated in the 70s and really cut my teeth on underwriting a wide variety of real estate, retail, hospitality, office, in these really illiquid structures. And the group that I worked with specialized in aggregating these little pieces together and then fighting for some kind of change, which in general involves selling the major assets of these structures or having them merge with a larger entity like a REIT to get liquidity for everybody involved. It was while working with these little pieces of real estate that one of our partners suggested that we use the platform that had been developed to aggregate these little pieces and aggregate trade claims.

2:23This is the era of, I think, the golden age of trade claims when bankruptcies such as Adelphia or MCI WorldCom had inconvenienced thousands and thousands of trade vendors. and the trade was not it wasn't a ready market but that trade could be accessed at huge discounts to value because the vendors really needed to sell the paper for their businesses and didn't want to be caught up in a large bankruptcy and so I pivoted from underwriting real estate to learning everything I could about distress and frankly I thought it was so exciting and so interesting combination of legal, financial, at times psychological motivations of all the different players at the table of a distressed company that I, as much as I could, made that my focus with regards to the seat that I had.

3:27Learning whatever I could, attending any conference I could, studying, again, studying the law, studying the rights, studying the history of what happened in various cases. And it was while I was doing that work that I came across some municipal bonds that were caught up in a bankruptcy. And buying the trade, as you probably would guess, was somewhat of a pain. You were talking to vendors, negotiating pricing. and I while doing that we were buying the notes of a co-op called farmland industries they had sold notes to farmers so it was all very illiquid on par with with trade and we were aggregating these notes together some were as little as twenty thousand dollars some were as much as a hundred thousand dollars when I get a phone call and the individual on the other end of the call says I've got some notes in farmland industries that I would like to sell.

4:37It's$9 million worth of notes, and I'd like 60 cents on the dollar. And I knew no one had$9 million worth of notes. We had the list of the note holders, which was publicly available in the bankruptcy. and 60 cents in the dollar was the recovery to the note holders so i thought well certainly i'm not paying 60 but i also really took me a minute and what i realized this individual had it was a fund that had nine million dollars of municipal bonds they were calling notes and i knew that the municipal bond recovery was par plus. They were getting 100 cents on the dollar plus whatever interest they were owed at the time of filing.

5:26And so I hit that bid as quickly as I possibly could or hit that offer as quickly as I possibly could. And I thought this is a whole different area. I do not believe I would have ever had the opportunity to buy corporate distressed debt at that kind of a discrepancy to a known recovery, but the municipal world was so much more inefficient that I pivoted yet again and really started to concentrate on the municipal bond universe as a relatively untapped, but frankly, more efficient way of getting one's hands on distressed paper. And were there any experiences or lessons you learned early in your career that helped shape your core investment principles or who you are as an investor today?

6:21It's interesting. One of your guests said something that resonates very, very true with me, which is I wanted to be purchasing paper where I knew more about the paper than the person that was selling it to me. And it's a simple concept, but it is so key to, I think, making good investments. And that is the case. It was the case in illiquid real estate. It was the case in trade claims. It can be the case across the spectrum of securities, of course. But finding avenues where you can invest, where that is almost always the case, I think is a sure way of buying value. And I think it exists also with regards to municipal bonds.

7:14The other aspect, I think, of what I learned as an investor was one great way to make money is not to lose money. So protecting the downside, protecting the investment as a starting place, beginning with the price that I'm going to look to pay in a worst case scenario is going to protect my capital, I think is another great place to be. That exists also more so, I believe, with regards to senior secured paper versus unsecured paper. So as a credit investor in the distress space, there's more variability in recovery when you're at the bottom of the capital stack. And being a senior secured creditor, you run less risk that something that you can't underwrite, that you don't know about, could greatly affect your recovery.

8:14both because your legal rights are stronger because um the the unknowns are most likely to happen in the general unsecured portion of the capital stack and uh and then your rights as a senior secured creditor whether it's your right to credit bid or whether it's your right to um your legal fees whether it's your your the power that you have at the table all of that is so much higher with regards to being higher in the capital stack. So going back to the not losing capital, when you have those rights, when you have more of a certainty of outcomes because of where you're sitting, it's another place that I decided I wanted to be.

9:00And you can actually put those two together pretty tightly in that if you want to be more secure in the capital stack to limit your

9:12where you know more than the seller does, and ideally the seller doesn't realize that you know more than they do, you can get an attractive price for that risk. And so you can actually have good downside and still get a good yield over time. Well said. Yeah, agreed. And so that's something you learned early on. And rather than going and working somewhere and trying to navigate those markets, you decided to launch your own firm about 15 years ago, right after the global financial crisis. What motivated you to do that? You know, I would love to say that I knew that it was going to be a great time to start an investment firm and that I had been thinking about it for five years.

9:53But honestly, that wouldn't be true. I had a few things happen in my life personally. I had been the breadwinner in my household and my husband was finishing his education. He became a physician, but as you know, that's a long road. And at the same time that was happening, I received a phone call from someone that has since become a mentor that in essence said, I would be willing to give you money if you ever went out on your own. And I don't know that I would have had the impetus or even the confidence, frankly, in myself at that stage had I not received that phone call. But that really started, it really started me thinking.

10:46And it enabled me to have that confidence and to start really thinking about what that would look like. And then with the activities in my personal life changing at the same time, I thought, I think I can do this. I really think I can do this. and this is going to provide seed capital. I also was able to reconnect with a firm that I worked for years prior, more than a decade prior, and got in touch with them and asked if they would be willing to provide back office services and allow me to register and as an investment advisor on their platform. And they jumped at the chance and then it was the right time.

11:31And that was not as much design as luck, but it proved to be the right time to begin the firm. And I have never, ever looked back. It's been great. And I guess hindsight is 20-20, but at the time, it could have been also very scary because you had one of the worst periods since the Great Depression just happened. it's true although i do think as distressed investors you know you know when value is being sold uh you've seen it you know what it looks like because you're used to seeing it distressed investors are used to seeing things trade off when they shouldn't or they're used to underwriting value when the rest of the world is written off a company and so i don't actually remember feeling as though it were a riskier time, if you will.

12:25And in hindsight, I don't know that I believe it were a riskier time. I think it was just that there was so much paper falling so fast in industries that had so much value intrinsically that it was just an awful lot of fun. Um, great time to be looking at paper without a whole lot of competition. Yeah. I guess if you're used to operating inside the storm in the middle of a storm, and most people are not, they're terrified of storms. Uh, you have a very different orientation when you're inside of a storm. I think that's right. I think it's, I think it's very right. And, uh, you know, I talked with some distressed folks, um, prior to March at 20, we really hadn't seen a storm like that in a very long time.

13:18And you do take for granted those kinds of storms and your comfort within them pretty easily. I think since, I think March of 20 was certainly a storm experience. I think 22 and 23 in their own way, especially with regards to credit, were similarly disconcerting. And so we are growing a new generation, I think. But prior to march of 20 it was really smooth sailing as you know for so many years and i think march of 20 in part was so exciting because there were even less folks i think involved um keeping a cool head than in uh in 2010 and the tail end of 2009 yeah literally a once in a hundred year storm yes yes hopefully.

14:07Yes. How has your vision for Lapis evolved and how did it begin and how has it changed over the last 15 years? Yeah. I would say my normal, the MO going in when it was really just me looking at securities and looking at value and deciding something was exciting to buy, it was much more of a underwrite to a liquidation, underwrite to a trading opportunity. as I was able to grow the team, the skill set and the, frankly, just the manpower changed so that we could look at not only by the security with the intent of trading out of it, by the security understanding that the underlying assets are going to be sold, but also by the security knowing there's value in the assets and take the actual assets over if that's the best play involved.

15:06The ability to manage the assets and hold them for a few years other than just selling them to another entity because we didn't have the breadth of capabilities is something that's changed over time. And then I would say the other aspect that's changed over time is as we've become more known within the industry, have developed more relationships, we have also been seen as a solution with regards to capital, maybe prior to the distress happening. We're getting inbound phone calls to creatively solve situations before a bankruptcy filing, either from bondholders or by attorneys or by financial advisors.

15:54And that's been a change over time, too. And that really just comes about when folks have known you for a while. have been through a number of restructurings with you. And that's been pretty exciting. Why don't we talk about the municipal bond market? My sense is a lot of investors think of it, particularly on the general obligation side, it's safe, low-yielding bonds. That's where I put my safe money. But as we're going to talk about, it's a vast universe. Would you describe the municipal bond landscape at a high level and maybe talk about the fragmentation, the lack of information, the different types of assets, muni bonds back, and so on?

16:35Absolutely. The municipal bond universe is certainly made up of two main areas of, I would say, borrower types. Either general obligation bonds, which I do think, as you alluded to, is what we think of. The state of California or LA Unified, something to that extent. Those bonds are almost always investment grade. They're backed by the full faith and credit of a municipality. And they almost always trade very in line with where they should trade vis-a-vis a spread to treasuries or in line with the MMD marks. The other universe of municipal debt are revenue-backed bonds. And so these are in industries that the federal government and or state governments have decided are worthy of the extra boost, if you will, that would come from making the yield off of them tax exempt.

17:47So industries that the government has decided it wants to encourage, hospitals, senior living, low-income housing, workforce housing, education, transportation, Melrose, which are dirt bond-like developments that we have here in California. So again, what we're doing is we're encouraging investment in these industries by lowering the cost to borrow, by making that income tax exempt. This area of the market is almost always not guaranteed by the full faith and credit of a municipality. They can be investment grade, certainly. um cedar sinai for example is an entity with municipal debt that is going to trade also very efficiently but much of the universe is not investment grade or is not rated at all regardless of which end of the universe we're in the average municipal bond deal is only 10 million So there are many more small municipal issuances than there are state of California or University of California issuances.

19:09And so this is an incredibly fractionalized market. In addition, 99.7 % of the market is not quoted on a daily basis. There is no active bid-ask spread. and 97 % of the market doesn't trade. So most of this paper is sold once to an end holder and then is put away either in a municipal fund, directly with retail, maybe with a bank or an insurance company, to an ETF and doesn't come back out again. so when the paper does come out on the secondary market um the the combination of the fractionalized nature of the size and the lack of perhaps um understanding on the part of the buyers as to what that bond even really is does lead to a lot of inefficiencies in price much more so of course in the non-rated or lower-end rating area of the marketplace.

20:21If something's investment grade, it is going to, outside of a situation like March of 20, it's going to trade efficiently. But two-thirds of the market is actually the revenue-backed side of the market. And who are the largest buyers of muni bonds and what are their incentives? Tax-exempt income is the largest incentive of the municipal marketplace. And the largest buyers are municipal mutual funds and retail holders directly. And retail holders can hold those directly in their accounts through SMAs, specialty managed accounts. The mutual funds can be something as large as a Nuveen high yield fund or as large as a Nuveen investment grade fund.

21:14But there are also an awful lot of specialty funds, maybe short duration California fund, which is going to be a fraction of the size or a closed ended fund issued for very specific purposes, ostensibly to holders. Ultimately, the vast, vast majority is owned by retail investors, which makes the market a bit different than the corporate market. Right. And is your sense that most muni investors are seeking safety and at the first sign of trouble, they're quick to sell? Yeah, I would say that is the case, certainly depending on the kind of trouble and depending on the holder. And it's going, the fallen angel concept that exists not only in the municipal bond universe, but also in the corporate universe.

22:08Fallen Angels would be paper that started out investment grade and became uninvestment grade for some reason. That is going to be, in my experience, the kind of holder that sells the quickest and without regard necessarily to price. And it may be because they're running an investment grade fund and they cannot hold non-investment grade paper. It may be because their tolerance, as you alluded to, is so low that they just need to get out. But that's going to be the most dramatic, I would say, situation where that discount to value is available. is available. So give you an example of that. When American Airlines ran into financial trouble, the amount of paper that traded municipal bond paper backed by American Airlines after the trouble became evident was a huge percentage, 60 % of the paper traded within a week.

23:15And you would see that kind of a situation much more so than you may in, let's say, a Puerto Rican utility piece of paper, which never carried an investment grade rating. And in terms of the municipalities issuing the bonds, is there a wide dispersion across those and how they manage their finances? You just think about the fundamentals? Of the borrowers themselves? Yeah. Yes, I would say definitely, certainly. And I think the other aspect of municipal debt that is interesting and creates situations that you also don't find in the corporate side of the market is that so many issuers of paper in the municipal side of the market are actually nonprofits.

24:06And nonprofits have a different mission and often a different skill set than the corollary for profits in the marketplace. And so especially, and the other dynamic, in addition to the management differences, the mission differences, because there is no equity in a nonprofit borrower, there is no logical place for a borrower to go if they run into an unexpected expense that exceeds the cash they have on hand. This lack of equity is unique in, I think, in municipal bonds with regards to assets that do have a for-profit corollary, like senior living or hospitals or multifamily housing. An unexpected lawsuit, an unexpected capital expense need.

25:08And these borrowers have already given away a first lien with regards to these assets. They literally have nowhere to go other than perhaps donations to save a situation that's unexpected and expensive. And that's very different than a corporation that could go issue more stock. They would dilute their existing shareholders, but they at least have options or issue some preferred stock. that simply doesn't exist with the nonprofit borrowers in the municipal marketplace. And that's unique. And the backdrop that you're expressing demonstrates the inefficiency and the potential unusually high return for the risk-taken opportunities that may exist.

25:52I'm curious if you feel the market has changed over the last couple decades. Has it become more efficient or possibly even less efficient? You know, I would say it's constantly evolving. It's constantly changing. And it's gone through some different waves that were somewhat unique. Puerto Rico running into such severe financial difficulty was certainly a wave in the municipal marketplace where you had what was in essence a municipal borrower default. That was pretty close temporally to Detroit running into such trouble, San Bernardino, Vallejo. And so what that really eliminated was some of the confidence that buyers of municipal bonds had that this was always going to be safe.

26:46And then you had Meredith Whitney coming out and saying that municipal borrowers across the country were insolvent. We were going to see a huge wave of defaults. So that was an interesting difference. The confidence level went away. Any challenges to the operational health of a municipality really led to a sell-off in the paper that was unique at that period of time because it was so fragile. The confidence had been eroded. I would say more recently in 22 and 23, much the same as had existed with Treasury holders, the spike in interest rates really highlighted the long -dated nature of most municipal paper.

27:37Most municipal paper, unlike corporate paper, is 30 years long, sometimes longer. And so the rapid fall in value on a resetting of interest rates was so dramatic that I think it also really affected the owners of municipal bonds, their understanding of the safety of their paper coming off the heels, of course, of absolute low interest rates in 21. I think that was another development that changed the perception, the willingness to hold certain kinds of paper. More recently, I would say what we're seeing and what I think we're going to continue to see is in the health care end of the market, The cost, the cost inflation, especially with regards to labor and food, is affecting health care borrowers, including senior living and hospitals, clinics.

28:33And so the they're losing their credit ratings. Their cash is dwindling. and that also is somewhat unique to a specific, it is a specific borrower group within the municipal marketplace, but a fairly sizable one. And so hospitals that have had decades of positive NOI and strong market positions are going through a very challenging time right now. And that's a theme that is filtering through the marketplace. Nice. And I'm also thinking of it as an asset allocator. And there's all this money out in the system, trillions of dollars that are looking for attractive returns for the risk taken and opportunities to take advantage of that.

29:20And the backdrop that you're describing in the municipal bond market outside of the high quality bonds seems to fit that, where you can have attractive returns for the risk taken. And it's just interesting that a lot more money hasn't found its way into that pocket to basically reduce that excess return to the risk. And I think it will. I do think it will. I think the other interesting aspect of the municipal bond universe that we didn't touch on, but which does limit to a certain extent your borrowing universe, is the inability to really hedge municipal bonds in the same way that you can hedge corporate paper.

30:03You could apply interest rate hedges to try to protect yourself. But you can't short municipal bond debt absent a very tailored contract from Goldman Sachs or something similar. It just doesn't exist. You can't provide tax-exempt income to the entity that you are borrowing securities from. You can give them income, but you can't give them tax-exempt income that they could file with their taxes. So they're virtually unable to be shorted. Given the diversity of the paper, it isn't easy to apply other kinds of hedges, the CDS kinds of synthetic hedges that might exist, because the amounts of paper out there are too diverse, to fractionalize all the reasons that we talked about.

30:58And that creates, that limits a buying universe that provides efficiency through the ability to, from a sophisticated standpoint, protect one's downside or create more options to capitalize on volatility. In addition, I think the tax-exempt income, although it's important to us and we tailor what we try to purchase to provide as tax efficient of a return as possible. That's not the makeup of most alternative managers. And so the tax exemption, if you will, is wasted on most of the alternative investment firms that are in existence. And it's also wasted on most of the sophisticated investor allocators outside of ultra high net worth individuals.

31:52And so that also creates somewhat of a moat around the strategy. I know you do a lot of work in senior living. Is there a reason you focus on that area? And the reason that we focus on senior living has to do in part with there's a combination. We talked about it a few minutes ago. The management in the nonprofit space can be less sophisticated than the management in the for-profit space, in part because there is that lack of equity that one can provide to the management. If you don't have equity, you can't raise money. If you don't have equity, you can't grant equity to your management team. And so I think on balance, you tend to have a group that maybe isn't quite as motivated by profit as, let's say, the for-profit side of the marketplace.

32:47And salaries tend to be lower as well. salaries tend to be lower. It does tend to be more of a mission-driven area of the market. Senior living, though, is incredibly capital intensive. It is incredibly difficult from a management standpoint, and the fixed costs in senior living are very high. So you need to keep the lights on, you need to keep the kitchen running, you need to employ the nursing staff, etc. almost without regard to your occupancy level, much like a hotel, if you will. You just have to keep it at a high level. And so if you run into trouble and occupancy starts to fall, if you stop investing in your facility and your facility looks tired, this lack of capital, lack of good management really starts to spiral senior living, and it can start to spiral fairly quickly.

33:49Your occupancy doesn't need to fall more than 10 points for you to be in the difference between losing money and breaking even. Without those significant cash reserves, that's where the distress seems to be. And yet the cost to recreate these assets is very high. These are expensive assets to build. And so the underlying value we see, the fix we understand generally, and we see situations where holders are, of course, running for the exits, and the situations are getting pretty dire, but it's fixable. It is something that can be remedied, maybe with more money coming into the facility, almost always with a management change at the facility.

34:39And so because that's where the distress is likely to happen, that combination of both the distress and the underlying asset value, those are the things that we're going to look for with regards to where we're going to put our capital. And one relatively recent period that where that sector faced severe distress was during COVID. Would you talk about that period and the opportunities that came out of it? Yeah, COVID has had a tail in the senior living industry. It certainly was incredibly challenging for all senior living borrowers. We had some facilities where you had 50 % of the population saying that they didn't want anyone coming in and they didn't want anyone being able to leave to protect themselves and another 50 % of the population wanting to see the grandkids and wanting to be able to leave the facility.