SPANISH FORK — In 1979, Spanish Fork sold municipal bonds to help Kmart Corp. finance a new store in a shopping center on the outskirts of town.
Two decades later, those bonds and almost 100 others that Kmart owes may default after the second-largest U.S. discount retailer filed for bankruptcy. Kmart guaranteed payments on more than $100 million of debt.
Spanish Fork was not the only Utah city involved with special funding efforts for Kmart, but it appears most are more likely to be hurt by lost sales and property tax revenues, should local stores close, than any repercussions should Kmart default on its bond payments.
American Fork officials say they are relieved to have avoided bonding problems. The city opted to use tax increment funding — a process of allowing a developer to use portions of its property tax obligation to repay construction debt — rather than using municipal or industrial bonds.
"You're going to see some ugly surprises in the bunch" of muni bonds sold on behalf of Kmart once the retailer terminates leases at locations it doesn't want, said Mark Doyle, president of Sterling Grace Municipal Securities in Spotswood, N.J.
The prospect of defaults on the municipal debt backed by Kmart, based in Troy, Mich., underscores the risk of so-called industrial development bonds. Issued to finance everything from hotel chains to factories, about $8 billion of such bonds are sold each year, and they default on average at a rate of 15 percent. By contrast, other tax-backed muni bonds have non-payment rates of less than 1 percent rate, according to a study by rating company Fitch Inc.
The price of the debt may vary based on the prospect specific stores will be closed, analysts said. Municipal bonds for stores that remain open or for property that attracts new tenants will rebound. Kmart may close as many as 500 of its 2,114 stores and plans to terminate leases on 350 stores that already are shuttered or being rented to other retailers.
Small amounts of the Spanish Fork debt, which was refinanced in 1993 to capitalize on lower interest rates, traded at less than 70 cents on the dollar this month.
However, city officials said they allowed the developer, CDK, to use the city's name to sell the bonds and it is the developer who is still responsible for the debt. "We assisted them to come in," said Spanish Fork City Manager David Oyler. "But the city is not responsible for the debt."
Other Kmart-backed munis changed hands at lower prices after the company's credit ratings were reduced in January. Moody's Investors Service cut those bonds to "Caa3;" Standard & Poor's downgraded them to "D."
"It's tough to make a blanket statement about the real estate," Doyle said. "There's very different stories among all of these bond deals."
While industrial development bonds carry more risk, they often give higher yields than regular muni bonds.
Oyler said he's optimistic the Spanish Fork Kmart may not close. The site is attractive, he said, because the city's population has tripled to 24,000 over the past couple of decades. Still, the store faces more competition after Wal-Mart Stores Inc., the largest retailer, opened a new store a few miles north in Springville.
"All the cities are competing with each other on the sales tax issue," Oyler said.
Farmington was in the middle of issuing some new bonds related to the RDA in the area around Kmart when word of the company's bankruptcy filing got out. The city negotiated with its bank to have the option of reducing the amount of outstanding bonds if it became apparent the city would lose money from Kmart.
But the RDA bond is not the largest concern, Mayor Dave Connors said.
The local Kmart, which opened more than a decade ago, is one of the city's three main sources of sales tax revenue, and the city would lose between $50,000 and $60,000 a year in revenue if the store shut down, a significant portion of the small city's budget.
American Fork administrator Carl Wanlass said Kmart built there about nine years ago. "It was a redevelopment project but it was never bonded for," Wanlass said. Instead, American Fork opted for a simple tax increment arrangement. Wanlass said Kmart finished repaying the city in full several years ago. If American Fork loses its store, it could cost the small city about $70,000 annually in sales tax revenue. American Fork is gaining a Super Wal-Mart, which city officials hope will at least offset the possible loss of a Kmart.
Contributing: Bloomberg News, Geoffrey Fattah, Elyse Hayes, Rodger Hardy