Welcome to Fed Watch Week. Once again, global financial markets will be hanging on every utterance made by Chairman Bernanke following Wednesday’s Federal Open Market Committee meeting. Everyone is, of course, looking for further clues regarding the timing of “Fed tapering”. Given the market turmoil that resulted from his comments last month, we assume the Chairman will seek to calm the markets this time while keeping them on notice regarding the eventual winding down of the Fed’s bond purchase program.
At the end of the day, market participants do realize the Fed’s actions from this point on will be totally data-dependent. Every major piece of economic news that comes out over the next few months will have the potential of influencing the Fed’s view on the economy, a recipe for further market volatility if we ever saw one.
After holding steady for a few days last week, Treasuries sold off late Monday, with yields back up to 2.21% and 3.37% for the 10-year and 30-year bonds, respectively.
So far this week, the municipal market appears to have found some degree of stability, with some buyers tip-toeing back into the water in otherwise quiet secondary activities. Detroit bonds have held up reasonably well as investors continue to digest the implications of last Friday’s restructuring proposal (more on this below).
As is usually the case after a major sell-off, any significant rebound may be met by renewed selling pressure as traders who got caught the first time around jump on another chance to reduce their exposure.
New Issue Market
As the tax-exempt market pauses to catch its breath, this week’s new issue calendar shouldn’t cause much of a stir. Supply is projected to be around $6.4 billion, featuring a $764 million California Health Financing Authority deal for St Joseph’s Health System (A1/AA-/AA-). Other notable issues include $400 million for the New York City Municipal Water Finance Authority and a $369 million for Dallas Fort Worth Airport.
High yield investors may want to take note of a $225 million New Jersey Economic Development Authority Special Facilities issue for Continental Airlines (B2/B). Although the United-Continental merger went through some rocky times last year, it appears the company has now gotten its act together and stands to fully participate in the airline industry’s newly-found financial stability. This week’s issue is actually a remarketing of two older Series, $48 million Series 2003 and $177 million Series 2000. The price talk on the former is approximately +240 to the 2033 maturity, with a 10 year/103 call, and +260 to the 2030 maturity on the latter with a 10 year/101 call. Given where we are in terms of the rate cycle, and assuming one is comfortable with the outlook for rates, we find it reasonable to give up a little call premium in favor of a wider spread and thus would tend to favor the Series 2000, all other things equal.
The G.O. Pledge, Detroit Style
As one major municipal entity tries to exit bankruptcy proceedings (Jefferson County, AL), another one appears to be on the road to Chapter 9. To no one’s surprise, the city of Detroit entered the annals of municipal default on Friday by skipping the coupon payments on certain of its debt, as part of the debt restructuring plan it presented to creditors.
The Bond Buyer did a good job of summarizing Emergency Manager Kevyn Orr’s proposal: “Today’s report that the city’s Emergency Manager gave to creditors divides Detroit’s GO debt into “secured” and “unsecured” categories. The secured debt consists of bonds that are backed by both the city’s GO and a state aid intercept pledge. The unsecured debt consists of all the other GO debt Detroit has outstanding. The report indicates the city will also cease payments on the remaining series of unsecured debt (…)”.
Based on our first pass through the 128 page proposal, it appears the so-called “secured” debt may be subject to some degree of restructuring (maturity stretching, coupon reduction, security pledge change etc…) but no haircut in terms of principal. The real shocker here lies in what Mr. Orr, with his corporate bankruptcy background, considers to be “unsecured” city debt.
Under the proposal, the city will treat about $2.5 billion of its debt as “unsecured” and on a parity with $5.7 billion of other post-employment benefit liabilities and $3.5 billion of unfunded pension liabilities. Those include $1.4 billion of pension certificates, $161 million of limited tax GOs and $369.1 million of unlimited tax GOs backed only by a full faith and credit pledge. Mr. Orr is proposing issuing $2 billion of notes to pay off holders of the $11.4 billion of unsecured debt on a pro-rata basis, for a recovery rate of about 17.5 cents on the dollar.
It’s the inclusion of the unlimited tax GOs that has muni market participants up in arms. Traditionally, the market has always viewed the “full faith and credit” pledge as the highest type of security a bond investor can obtain, as it obligates the issuer to raise taxes as much as necessary to pay its G.O. debt. Apparently, Mr. Orr interprets this full faith and credit pledge merely as a “residual interest”, payable only from whatever resources are left after all specific revenue pledges have been satisfied. Needless to say, this is a ground-breaking interpretation that flies in the face of decades of municipal industry practice, one that will certainly be vigorously fought in court and debated among muni professionals for months to come.
On the good news side, Mr. Orr does consider the existing $5.9 billion debt of the Detroit Water & Sewer Department (DWSD) to be “secured”, which is consistent with traditional market views. However, once restructured and refinanced, the DWSD debt will no longer be secured by gross revenues, only by net revenues after operating and maintenance costs. We view this as a material loss in security, particularly for a system that has been as under-capitalized and under-maintained as Detroit’s.
Interestingly, the debt restructuring proposal also contemplates an eventual spinoff of the DWSD. Muni investors have long realized that the water & sewer debt has been unfairly tainted by its association with the city, even though its service area extends well beyond city limits into many of the adjacent and wealthier suburbs. Mr. Orr recommends spinning off the department into a new, stand-alone entity called the Metropolitan Area Water & Sewer Authority. The city would either permit this new Authority to operate the DWSD assets through either a concession agreement or a lease agreement. Although the new entity will be free to establish a brand new retirement plan for future employees, the city would retain all legacy pension obligations. Obviously, many more details will need to be worked out, but it sounds like a worthwhile idea nonetheless.
When it comes to the water & sewer debt, getting rid of the Detroit name makes sense to us, although we’re not sure we like the new acronym “MAWS.” After all, the last thing bondholders need is to get bitten again by a Michigan bond issuer.
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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