Dirt Bonds in Florida Lead Municipal Bond Defaults

Dirt bonds, or bonds that are used to build water and power lines as well as roads in newly developing communities are showing some of the highest default levels in the municipal bond category. The epicenter of defaults - Florida.

Richard Lehman, editor of the Florida-based newsletter Distressed Debt Securities says that dirt bonds represent "...the single biggest default wave in the history of municipal bonds."

Florida is particularly vulnreable because it created special community development districts. According to an article on the Distressed Debt Securities website:

"Private developers who obtained the CDD designation for their land holdings qualified for tax-exempt municipal bond financing, which is cheaper than loans that yield interest subject to income tax. Developers typically have used the proceeds of CDD bond issues to build streets, sewers and other infrastructure to support a residential community. Responsibility for repaying CDD bonds is supposed to shift gradually from the developers to home buyers. But many of these districts defaulted because they attracted too few buyers of homes and home sites."

There are 600 of these community development districts in Florida and Lehman estimates that 1/3 of these have or will default. According to a report to the Florida Legislature:

"As of March 1, 2010, 122 districts have defaulted on $2.997 billion in bonds. A further 78 districts representing $2.705 billion are on our watch list of bonds likely to default in 2010."

Some investors who have purchased dirt bonds are selling them at distressed prices. An article in Bloomberg covers how Eaton Vance dumped its dirt bonds for an estimated 27 cents on the dollar. According to fund manager Thomas Metzold that was better than assuming ownership of the property and having to deal with taxes, development, and ongoing costs.

“We’re managers of municipal bonds, not real estate people,” said Metzold.

States and municipalities are not liable for dirt bonds defaults. The bonds are secured through land values and any resulting taxes, assessments or sales that occur on that land. The problem is that if the land value drops and development ceases, the collateral may not cover the value of the bond or be able to meet the bond payments.

In that case, investors can sell the bonds at a loss, as Eaton Vance chose to do, or hold on and hope that development, tax revenue, and land values increase.