The recent rally in the fixed-income markets came to a screeching halt last Friday as the Non-Farm Employment number came in at 176,000 – beating all expectations. Even more impressive are the significant 114,000 upward revisions to the two prior reports. For once, the drop in the jobless rate to 7.5% could not be attributed to workers dropping out of the labor force.

In the wake of such a strong employment showing, long Treasuries have gravitated back to their natural habitat, around the 3.00% level. The bond bears came out of hiding again, including one Warren Buffett, the “Oracle of Omaha”. Mr. Buffett declared bonds a poor investment on CNBC, artificially propped up as they are by the Fed’s quantitative easing efforts.

For once, the drop in the jobless rate to 7.5% could not be attributed to workers dropping out of the labor force.

The funny thing is, we could have said the same thing about the stock market. Could anyone really argue with the fact that the equity market has also benefited from the massive amount of liquidity provided by the Fed? Let’s face it, both stocks and bonds are acting like drunken guests who won’t start behaving until the punch bowl gets taken away.

Until such a time of reckoning is upon us, however, the economy should remain in this rather sweet spot where growth will be steady but lackluster, making it very difficult for the Fed to pull the plug. This is the kind of environment that should favor, we believe, credit risk over duration risk.

Illinois Back in the News – in a More Positive Way

Tax-exempt bonds held up well during Friday’s selloff, but did soften by 5-6 basis points on the long end as we start this new week. The new issue calendar should be considerably lighter this week, with just under $5 billion on the docket. Most deals will be under $250 MM and should not pose any distribution problem. The competitive side will be anchored by two taxable issues from Illinois, a $300 MM Build Illinois Bond issue (rated AA+ by Fitch on the basis of a dedicated sales tax pledge) and a $205 MM Illinois Finance Authority issue for the University of Chicago.

… the recent passage of a significant pension reform bill by the Illinois House has given market participants reason for cautious optimism.

Speaking of the Land of Lincoln, the recent passage of a significant pension reform bill by the Illinois House has given market participants reason for cautious optimism. Could it be that Speaker Mike Madigan has finally decided that Illinois should follow that shining example of fiscal probity…Puerto Rico? Or has he now realized that a busted pension system is not the kind of legacy he wants to leave behind?  Of course, this being Illinois, nothing is assured until it is actually signed into law. The pension plan is expected to face its toughest test in the State Senate, where concerns about a potential constitutional challenge dominate. As Illinois prepares to come to market with up to $2 billion in new financings, much will ride on what can be accomplished before legislators adjourn on May 31st.

Jumping on the Revenue Bond Bandwagon? Not So Fast…

The National Federation of Municipal Analysts (NFMA) held its annual conference last week in San Diego, California. The turnout broke all records, as muni connoisseurs (mostly from the Midwest and Northeast, surprisingly) descended upon America’s Finest City in search of spring-like weather. The excellent program covered dozens of topics of interest to public finance and muni investors, which we will be happy to discuss in upcoming columns.

Chapter 9, the municipal bankruptcy proceeding, is, of course, always on the agenda. Many institutional investors have been quoted in the media as avoiding G.O. debt in favor of revenue bonds. One of the reasons cited for this preference is the fact that, in Chapter 9, the automatic stay usually does not apply to revenue debt.

However, just like everything else in a bankruptcy case, some qualification to that rule is in order. Investors should realize that a Chapter 9 filing effectively converts a “gross revenue pledge” to a “net revenue pledge”. A net revenue pledge opens the door to a potential re-interpretation of what constitutes “necessary” operating expenses that may be paid ahead of debt service. This is precisely what the folks in Jefferson County, Alabama went after. The county sought to include capital expenditures, reserves for future capital expenditures, reserves for depreciation and amortization, and payment of bankruptcy professional fees and expenses as “permitted operating expenses” in addition to those already defined by the Indenture.

In the Jefferson County case, the bankruptcy court ended up deciding that the net revenue pledge as defined in the indenture was a Special Revenues pledge and therefore, under Section 922 (d) of the Bankruptcy Code, no automatic stay was applicable. The county stopped making net revenue payments upon filing Chapter 9 in November 2011, but after the ruling, was ordered by the court to resume all payments, including all net revenues dating back to the Petition Date.

Although the Jefferson County ruling was a positive for bondholders, it was based on a fairly narrow reading of the revenue pledge contained in the issue’s indenture. Depending on how they’re written, other revenue bond indentures may be more vulnerable to a re-interpretation of necessary operating expenses. For instance, a sewer system operating under an EPA restraining order that can be shown to have underinvested in its plant and equipment, may argue that its capital expenditures should come ahead of debt service.

As bankruptcy judge Chris Klein (of Stockton fame) reminded our national audience of municipal analysts last week, given the dearth of legal precedent, the case law on Chapter 9 is still being written and investors will be well served not to over-rely on simple generalizations.


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