By Triet Nguyen, Axios Advisors LLC
April 16, 2013
As former Bostonians, our thoughts and prayers go out to the victims and families affected by yesterday’s tragedy.
Welcome to the premiere installment of Muni Bond Insights. We’re grateful to MuniNetGuide.com for providing a new forum for independent (and hopefully unbiased) views on current developments in the U.S. municipal bond market. Much of the published market commentary out there comes from either broker-dealers or large institutional investors, hardly objective sources of market wisdom in our eyes. Through this new bi-weekly column, we hope to provide a fresher, sometimes irreverent, take on market events. Your feedback will be most welcome as we fine-tune the tone and content to make this a useful tool in your muni investing arsenal.
For most of us, another Tax Day has just come and gone. This year’s ransom to the IRS came with the realization that the value of a tax-exempt income stream has not been higher since the 1980s. Consider the fact that, after last year’s various tax increases at the federal as well as local level, the top marginal effective tax rate (TMETR) for the average U.S. resident now stands at a whopping 48.2%, according to a recent study by Professors G. Prante and A. John from Lynchburg University. This means that, by our modest calculations, a 4.00% tax-exempt yield is now equivalent to a 7.72% yield pre-tax.
The passage of Proposition 30 in November did wonders for CA bonds: it helped improve the State’s fiscal outlook while making the value of the state tax-exemption even more valuable to high income earners.
California residents have it the worst: their TMETR is now 52.6%. Any taxable fixed-income alternative has to yield more than twice as much to compete with CA tax-exempts. The passage of Proposition 30 in November did wonders for CA bonds: it helped improve the State’s fiscal outlook while making the value of the state tax-exemption even more valuable to high income earners. Is it any wonder that last week’s State of CA G.O. issue was upsized to $2.72 billion?
Ironically, the more valuable municipal bond interest is to individuals in higher income brackets, the more it becomes a political target for politicians with a bent toward class warfare. In its fiscal year 2014 Budget released last week, the Obama Administration reiterated its proposal to cap all tax deductions, including muni interest, at 28%, much to the dismay of the public finance community.
Away from the tax-exemption issue, the other 600-pound gorilla in the muni market continues to be, of course, Puerto Rico (PR). As many other market observers, Axios included, have pointed out, the credit outlook for this U.S. territory and its various instrumentalities remains the single most significant systemic risk factor in our market. Credit spreads on PR bonds have ballooned from around +190 in 2011 to +330 currently, particularly in the 10-year portion of the curve. So far, the impact of the spread widening has been primarily on relative – not absolute – performance, courtesy of the historic fixed-income rally of the past two years. Once the rate outlook stabilizes, the underperformance of PR bonds is bound to translate into real losses.
After a botched attempt at reassuring investors through an outreach meeting in New York a few weeks ago, the Padilla Administration had no choice but to ram its pension reform proposal through the legislature. While passage of the pension reform package was certainly a positive step, the Commonwealth still needs to deal with its structural deficit problem in order to keep its rating out of “junk bond” territory. It should be noted that any long-term pension reform attempt always comes with higher short-term fiscal pain as government employees pre-emptively take early retirement in order to beat the proposed changes.
Away from the tax-exemption issue, the other 600-pound gorilla in the muni market continues to be, of course, Puerto Rico.
The next hurdle for investors should be the Commonwealth’s upcoming spring financing, which may range anywhere from $775MM to $2 billion. Continued market access is critical to PR’s fiscal survival, of course, and so that deal will be intensely scrutinized by the market. You may recall that, at this time last year, Barclays brought to market another PR issue which was priced as much as 60 basis points cheaper versus where bonds were trading in the secondary at the time. Arguably, that deal marked the beginning of the yearlong selloff in PR bonds. Since the PR credit situation can hardly be seen as improved this time around, investors will be biting their nails until a market-clearing level is established for the new deal. For what it’s worth, the contrarian investor in us would probably look to purchase bonds in the secondary market just ahead of the new issue pricing, when the pressure on PR will be at its peak.
Last but not least, the Obama Administration’s recently announced desire to fast-track an eventual vote on the Statehood issue through a plebiscite will all but assure continuing volatility for PR bonds this year.
New Issue Market
The market successfully slogged through a fairly heavy $7.5 billion calendar last week, anchored by the aforementioned State of CA G.O. issue. Transportation issues are heavily represented on this week’s calendar: the headline negotiated issues will include $875 MM NJ Transportation Trust Fund ($540 MM tax-exempt, $335MM taxable), $690MM NJ Turnpikes, $500MM Illinois Tollways and potentially a $368MM Dallas & Ft Worth Airport issue.
The tax-exempt NJ Trans will have serial maturities from 2013 to 2024. Price talks range from 3.00% coupon to yield 0.42% in 2014 to a 5.00% coupon to yield 2.62% in 2024 (Note the high dollar price but non-callable structure).
The week’s more attractively priced issues in terms of yield will likely be the IL Tolls and the DFW Airports. The latter, in particular, was recently downgraded by Fitch from A to A-.
Now that tax time is over, the market’s reception to this week’s offerings, as well as the weekly mutual fund flows, should confirm whether or not the recent bout of muni underperformance was just due to seasonal factors.
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