By Gunjan Banerji and Heather Gillers
Investors are flocking to riskier corners of the traditionally safe municipal bond market in a search for yield.
They are buying hundreds of millions of dollars of debt issues from unrated and below-investment-grade borrowers such as energy projects and upstart charter schools.
It is a shift within a part of the bond market commonly considered almost as safe as Treasurys. Municipal-bond payments are often backed by taxes or revenue from essential services. The bonds are known for low default rates and prized by investors for stable returns and interest payments that are typically tax-free.
Yet the return of superlow rates this year has driven investors to seek out less traditional versions of muni bonds that offer higher returns. On Wednesday, the Federal Reserve cut rates by a quarter-percentage point for the second time in recent months, to a range between 1.75% and 2%.
The sale of riskier new bonds, combined with the deterioration of some existing debt, has increased the amount of junk-rated and unrated debt outstanding by 20% since 2012, according to Municipal Market Analytics and the Federal Reserve.
It remains a small slice, about 9%, of the $4 trillion muni-bond market, according to MMA and Fed data. But high-yield municipal funds have attracted more money in the year to August than in any other year on record, drawing $14 billion, according to Refinitiv data going back to 1992.
The appetite for muni debt includes less traditional offerings in which governments extend their tax-exempt borrowing power to efforts to build or renovate hospitals, dormitories, energy plants, and even malls and stadiums.
For example, investors recently welcomed the largest unrated charter school deal ever, according to Equitable Facilities Fund, which tracks the market. Overall issuance in that sector has risen roughly fourfold over the past decade.
Bonds such as these aren't backed by a promise to raise taxes if necessary, as is often the case with cities and states seeking funds. As a result, they typically offer additional yield to compensate for that risk -- income that has proved tantalizing for investors after years of rock-bottom rates.
"We are seeing more speculative projects find their way into municipal bond financings today than we have over the last handful of years," said Robert Amodeo, head of municipals at Western Asset Management.
Already, though, there are some worrisome signs. Reports of problems filed by borrowers -- ranging from outright defaults to tapping cash reserves to make payments -- so far this year have reached the highest level since 2015, according to MMA. There were 101 such issues through August, compared with a five-year average of 90, MMA data show.
While overall municipal defaults remain rare, the probability of a speculative-grade muni bond defaulting within 10 years has ticked up. It rose to 12% over the past decade, compared with 4% for the period from 1970 to 2008, according to data from Moody's Corp. on bonds rated by that firm.
Recently issued debt -- both speculative and investment-grade -- also is going sour more quickly. Among bonds that have reported impairments since 2017, some 40% encountered that trouble within three years of being issued, MMA data shows. In the previous seven years, an average of 24% of impairments affected debt issued that recently.
"God help us if there's a recession," said Tom Doe, president of MMA.
Some investment-grade rated bonds are also deteriorating quickly.
Last year, ratings firm S&P Global Inc. downgraded to junk roughly $250 million in bonds issued by nonprofit Provident Oklahoma Education Resources Inc. to build student housing and a parking garage on the University of Oklahoma campus in Norman, Okla. The project hadn't yet been completed, but it had become clear not enough students wanted to live there, weighing on the nonprofit's revenues, S&P said in a report.
This August, after the project had been completed, the company didn't have enough money on hand to make a bond payment and had to draw on its reserves, according to a disclosure on Electronic Municipal Market Access, a public bond database.
S&P further downgraded the debt eight notches and said revenue and reserves may not cover debt payments next year.
Steve Hicks, president of Provident Oklahoma, has blamed the university."We have never had a university fail to honor their commitments to support their projects to the degree that OU has on this project," he said, adding that the university didn't renew a lease on commercial space or a license on parking, as Provident had anticipated.
A spokeswoman for the university said it "met all of its legal obligations" and that the university "has a responsibility to act in a fiscally responsible manner and in the best interests of the students and citizens of Oklahoma."
For now though, investors are focused on yield, not risk.
"We have a food fight going on by investors," said J.R. Rieger, author of the Rieger Report, a bond market newsletter. "If there was a fiscally weaker municipality that needed to raise funds, this is the time to do it."
In 2017, charter school International Leadership of Texas fell afoul of its required debt-service coverage ratio, a measure of how much cash the school has on hand to make bond payments.
Around that time, the fast-growing school system ended up laying off about 60 staff members to save millions in payroll annually to meet its required ratio again.
But investors snapped up a $357 million offering from the school system last year, the largest unrated charter school deal on record, according to the Equitable Facilities Fund, which helps charter schools secure financing.
It is "one of the reasons that we were able to grow," Eddie Conger, the school's superintendent, said of the bond issue. He said the school has made adjustments since 2017 and added that he is contemplating a return to the bond market next year.
The willingness of investors to look past prior problems is also allowing some issues to add debt yet cut borrowing costs. Palomar Health, a hospital system in Southern California has struggled with union contract negotiations and low levels of cash in the past, according to a Moody's report.
But it was able to borrow an additional $60 million while refinancing debt in 2017. And its interest costs fell by half a million dollars a year, said Carlos Bohorquez, the hospital's chief financial officer.
"It was a win-win," said Mr. Bohorquez.
Write to Gunjan Banerji at Gunjan.Banerji@wsj.com and Heather Gillers at email@example.com