The Treasury market finally found some degree of support this morning after a four day losing streak that took yield levels to a two month high. While the economic data, here and abroad, continue to be mixed, fixed-income market participants have become much more sensitive to any sign of resurgent growth and the timing of “Fed tapering” efforts.
The tax-exempt market also marked time this week as it looks ahead to potentially higher reinvestment flows from bond redemptions in June and July. One factor that may also provide some technical support: beginning Friday, the Treasury Department has announced it will suspend the sales of State and Local Government Series Securities until further notice, as one of the first maneuvers to avoid hitting the federal debt ceiling. These securities, affectionately called “SLuGS” by traders, are used to fund collateral accounts for refunding bond issues and allow issuers to comply with arbitrage rules. To the extent that issuers will have to go buy cash Treasuries in the open market to replace the use of SLuGS, refunding volume may suffer accordingly.
On Tuesday, the SEC held another one of its Roundtables, this time on the topic of credit ratings. A replay of the webcast may be found here. As we view this as a critical subject matter for the fixed-income markets, we’ll take some time to mull over what we heard and share our thoughts with you in next week’s column.
Detroit’s Emergency Manager, Kevyn Orr, released his first report on the financial status of the city this week and, predictably, painted a fairly grim picture. (For a feel for what it’s like to actually live in Detroit, check out reporter Charlie LeDuff’s recent book, “Detroit: An American Autopsy.“ The title says it all.)
Readers are encouraged to read the actual report, as it is a fascinating read. In fact, if you strip out the outrageous City Hall corruption under the Kilpatrick Administration and the demographic trends that are somewhat unique to Detroit, the city’s fiscal problems echo those experienced by other ’distressed” local governments around the country. This laundry list includes among other things: a structural imbalance between revenues and expenditures; poor cash flow management leading to deferral and underfunding of pension obligations; under-spending on capital expenditures and “mature” retirement systems where the ratio of active employees to retirees and beneficiaries is well below 50%.
The financial press scoured the report for clues on Mr. Orr’s potential plan of attack and was rewarded with this statement of intent: “Restructuring the City’s liabilities in a fair and equitable manner across all relevant stakeholders is necessary for the City’s operational and financial survival. In fact, it is overdue. Importantly, the restructuring of this debt is not simply a means to help the City service its existing obligations. The restructuring of this debt must be viewed in the larger context of returning the City to overall financial health and future sustainability. The restructuring of the City’s debt and other liabilities is essential to provide the City with a strong balance sheet and the financial foundation to raise new capital, attract new public and private investors and make the necessary reinvestments in the City (…)”
Obviously, Kevyn Orr is putting all the city’s stakeholders, including its bondholders and its employee unions, on notice that everyone should expect to see a haircut as part of the restructuring plan. Many restructuring experts view this as laying the groundwork for an eventual Chapter 9 filing.
As analysts, one of the comments that caught our attention was a cryptic reference to the Water & Sewer debt: “The current credit ratings for this debt and the cost of capital currently available to DWSD may not accurately reflect the quality of DWSD’s projected revenue streams or the achievements associated with DWSD’s ongoing operational restructuring initiatives (…)”
Apparently, the Emergency Manager and his staff feel the water and sewer debt is currently mis-perceived and mis-priced by the market. While the statement does not actually specify whether current prices are too high (i.e. yields are too low) or too low (i.e. yields are too high), we can safely assume that, from an issuer’s perspective, it’s always the latter. Given that the water & sewer debt is the only city debt still rated investment-grade (and the only issue still enjoying decent institutional buying interest), we’re not quite sure where Mr. Orr is coming from. While the utility debt is arguably still self-supporting, it is not clear how it will be treated in the event of a bankruptcy filing by the city, so there’s still plenty of risk to the bondholders. In fact, any action Mr. Orr himself might take that undermines the autonomy of the utility system would not be viewed favorably by the market.
One of the key attractions of the Detroit water & sewer debt is the fact that its service area goes well beyond the city’s boundaries. According to the Bond Buyer, the system currently serves about 43% of the state’s population, with 70% of revenues coming from outside the city. Yet, just last month, the city of Flint, a major participant, pulled out of the system to join the Karegnondi Water Authority project. More defections from other participants who may not want to be associated with the Detroit stigma would undermine the system’s long-term viability. At a current spread of about +120 off AAA to maturity, the senior lien water & sewer bonds are fairly priced, in our opinion.
The Emergency Manager’s Report should also be of great interest to crossover investors, primarily hedge funds specializing in distressed strategies. The fractured and disparate nature of the municipal market is an ongoing source of frustration for hedge fund investors accustomed to billion dollar opportunities on the corporate side. With close to $9 billion in long-term debt, the Detroit situation has the potential to provide the “scale” they desperately need, particularly if the city does end up in bankruptcy. We do note that a substantial amount of the debt has been insured, making the bond insurers key players in the proceeding and reducing the amount of debt potentially “in play”.
Of course, these vulture investors may also find out that in the municipal world, where sovereignty and political expediency often trump financial common sense, turning a profit on a “distressed” opportunity may not be quite as simple as in a corporate bankruptcy setting. Detroit G.O. s are currently trading in the low 80s in terms of dollar price, reflecting the high historical recovery rates on defaulted essential service issues. That is still well above the desired entry point for most distressed investors, usually between 10 to 40 cents on the dollar. Just two weeks ago, at the NFMA Conference, Judge Larry Klein reminded us again how few tools a bankruptcy judge has at his disposal in a Chapter 9 case compared to a Chapter 11 filing.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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