[Note to Readers: This week’s columns were delayed due to vacation time and graduation season. Starting next week, MuniBond Insights will be published on Tuesday and Friday.]

Market Outlook

In the aftermath of last Friday’s better-than-expected payrolls number, the fixed income market continued to struggle this week, as rates ratcheted higher on Tuesday to hit a 14-month high of 2.27% on 10-year Treasuries. This triggered a selloff in government bond markets across Europe. To make matters worse, the Treasury also has to absorb new supply this week in the guise of three, 10- and 30-year auctions.

Given the magnitude and speed of the recent correction, municipals are starting to look quite attractive, as tax-exempt to taxable ratios now exceed 100% across much of the curve.

Bond yields finally stabilized when equity markets in the U.S. and across Asia started to sell off, ostensibly due to disappointment over the Bank of Japan’s decision to leave its monetary policy unchanged.

All in all, it looks like we’re in for a period of significant volatility as the financial markets try to adjust to the prospects of central banks around the globe winding down their stimulus programs.

At this point, the yields on 10-year and 30-year Treasuries appear on track to eventually retest last year’s highs (2.39% and 3.48%, respectively).

In the meantime, the other shoe has also dropped. After seeing the dismal returns for the month of May, bond investors are starting to vote with their feet. According to Lipper, investors withdrew over $9 billion from fixed-income mutual funds and exchange-traded funds (ETFs), the second biggest weekly redemption since 1992. Corporate high yield funds saw a new record weekly redemption of $3.2 billion.

Muni funds also experienced outflows of close to $1.5 billion for the week ending June 5th, compared to outflows of only $157 million the preceding week. High yield muni funds reporting on a weekly basis also sustained outflows of $501 million. As we all know, in muniland more than anywhere else, fund outflows tend to be self-fulfilling in the short-term: investor redemptions beget selling by the funds which in turn leads to more market weakness and even more redemptions, and so on and so forth.

Given the magnitude and speed of the recent correction, municipals are starting to look quite attractive, as tax-exempt to taxable ratios now exceed 100% across much of the curve. However, we would give the adjustment process a bit more time to run its course before picking an entry point. Liquidity in all fixed-income markets has been declining for some time and has yet to be tested by a true bear market scenario.

New Issue Market

On top of fading demand, the new issue calendar promises to be heavy this week, with a projected $8 billion in new issuance, compared to just $4.5 billion last week. The marquee transactions will include $877 million for Rutgers University and $800 million for the New York City Transitional Finance Authority (TFA).

The most interesting issue of the week will probably be the $1 billion refunding deal for Midwestern health care provider Ascension Health. This will mark Ascension’s first foray into the taxable market. About $600 million of the debt will be tax-exempt, primarily variable rate paper. In contrast, the $400 million taxable portion will consist of all fixed-rate longer maturity paper. Ascension’s senior debt rating is a relatively lofty AA-/Aa2/AA-, so placement shouldn’t be a problem even in the current sloppy market environment. Like many other health care issuers this year, Ascension is taking advantage of the tight spreads between tax-exempts and taxables and the lighter compliance requirements involved in the taxable issuance process (we plan to discuss the current boom in taxable muni debt in an upcoming column).

Default Recovery Rates in Munis, Revisited

One of the best arguments in favor of municipals as an asset class, aside from the historically low default rate, is the fact that, even for the few issues that have defaulted, the average recovery on local government GOs, tax-backed and essential service bonds has been almost 100%, save for a few missed coupon payments (Fitch, 2007). Unfortunately, the outcome of some of the current bankruptcy cases may challenge this “full recovery” assumption.

 … the average recovery on local government GOs, tax-backed and essential service bonds has been almost 100% …

Last week, Jefferson County and its creditors finally agreed on a plan to exit Chapter 9 proceedings. J.P. Morgan, the bond insurers and seven hedge funds, representing about 78% of the County’s $3.078 billion sewer debt, all signed Plan Support Agreements which, if approved by the bankruptcy court, should allow the County to exit bankruptcy by yearend.

According to the Summary of the Sewer Creditor Plan Support Agreements (“PSAs”), the creditors will receive about $1.835 billion in the aggregate, which equals an average recovery rate of 60 cents on the dollar. However, the actual recovery rates will vary significantly among the various creditor classes. For instance, J.P. Morgan’s will only receive about 30 cents on the sewer bonds and only 12 cents on its total claims, taking into account a complete waiver of all the bank’s swap claims against the County.

If our calculations are correct, once you back out J. P. Morgan’s share, the other creditors stand to recover a little over 78 cents. While this would normally be viewed as a fairly decent recovery rate, many market observers are dismayed that the creditors would agree to any haircut at all on special revenue debt. The traditional legal view holds debt secured by a special revenue pledge to be a “protected” class of security, and to accept anything less than 100% recovery on such debt would appear to set a new, unfavorable precedent.

Critics point the finger at hedge fund investors, who hold almost $900 million of the sewer debt, for setting this new precedent. While it would be unreasonable to blame those crossover buyers for voting their economic interests, it is true that their approach to the bankruptcy and workout process may differ sharply from the mutual funds’ traditional response. Mutual funds tend to be fixated on preserving the tax-exempt coupon income at any cost while hedge funds are more interested in the total return on their investment. The bond funds’ legal response is constrained by their prospectus guidelines while the hedge funds have more flexibility and more tools in their toolbox: in the JeffCo case, for instance, some of them will receive an additional $13 million in fees to backstop a potential sewer debt refunding issue for the County up to $185 million, an option that few mutual funds could take advantage of.

The next test of recovery rates on essential service municipals will come from – where else? – Detroit.  The Motor City has about $8 billion in debt outstanding, $5.4 billion of which are water and sewer bonds thought to be insulated from any potential reorganization.

Kevyn Orr, the city’s Emergency Manager, has scheduled his first meeting with creditors this Friday. With the Chapter 9 hammer in hand, Mr. Orr has been putting out clear signals that bondholders and insurers should expect to take a substantial haircut on their stakes. The Detroit Free Press reports that Mr. Orr’s opening salvo could be in the 10 cents on the dollar range, although we would take that as mere pre-meeting posturing. While it’s not clear if hedge funds have been able to accumulate much of a position in Detroit bonds, we would expect their presence to be felt here also, as it was in the Jefferson County case.

It is certainly too premature at this point to speculate on the eventual outcome of Detroit’s negotiations. That said, there is a real risk of further erosion of the expected recovery value on “protected” muni securities, especially if the water and sewer system bonds get pulled into the fray. Stay tuned.

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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