Market Outlook

This has been the kind of market that tramples even the most astute contrarian investors. Those who saw value restored in the bond market after May and June’s dramatic selloff barely had time to digest their holiday meal before they were faced with yet another interest rate surge.

The catalyst for the latest yield spike was, of course, the Non-Farm Payroll (NFP) report released on Friday. Coming in at an impressive 195,000, with another 70,000 upward revision for the previous two months, the report managed to beat even the most optimistic street estimates and sent yields on 10- year and 30-year Treasuries, surging more than 20 basis points toward the 2.75% and 3.70% levels, respectively. By Tuesday morning, however, 10-year Treasuries had settled down to around 2.63%, as the market consensus coalesces around a September 2013 time frame for the start of Fed tapering efforts.

… municipals continue to look extremely attractive relative to their taxable counterparts.

To the extent any conclusion could be drawn from last week’s thin holiday trading volume, muni yields also gave back 10-12 basis points on Friday and another 4-5 basis points yesterday. However, price discovery remained something of a challenge, particularly for underwriters who are trying to figure out the new market-clearing levels.

If nothing else, municipals continue to look extremely attractive relative to their taxable counterparts. According to the Bond Buyer, the 10-year ratio increased to 103%, above its three-month average of 99.6%. The 30-year ratio is even more compelling, as it closed at 109.1% on Monday, up from its three-month average of 101.3%. These are fairly extreme ratios, seldom reached historically, so the case for a duration-neutral crossover arbitrage trade still looks quite strong to us.

New Issues

After the holiday-shortened week, the muni calendar is building up again toward the $6 billion mark. Aside from the $764 MM California Health/St Joseph’s issue, a holdover from last week, this week’s new issue supply has a distinct transportation theme. On the negotiated side, investors will see $736 MM from Denver Airport, $410 MM from Dallas Fort Worth Airport and $425 MM from the Illinois Toll Highway. On the competitive side, the State of Utah’s $217 MM top-rated G.O. issue will also be earmarked for highway system improvement purposes. And these are only precursors to the year’s largest issue, a $2.86 billion behemoth offering from the Grand Parkway Transportation Corp., Texas, slated for next week.

One thing we know for sure: when the restructuring of Motown’s debt is completed, either in or out of bankruptcy, not many of the muni market’s legal “sacred cows” will remain unchallenged.

With supply building up again, the “disintermediation” trend out of packaged products into individual bonds appears to continue apace. Even as retail brokers reportedly struggle to meet the overwhelming demand from individual investors, municipal bond funds reported another $870.4 million of net outflows in the week ended July 3, according to Lipper. The bleeding from the funds has occurred at such a furious pace, even $800 million in redemptions were greeted by market participants as a huge improvement from the record $4.53 billion of outflows during the previous week. High-yield muni funds did post net inflows of $140.7 million, a reversal from net outflows of $1.2 billion the previous week. Muni ETFs had net outflows of $33.7 million, still down from $158.1 million of outflows during the previous week.

Local Distress is Costing Michigan Dearly

With the economy on the mend, credit trends have certainly turned positive for the tax-exempt sector, but more so at the state than at the local level. Detroit’s potential bankruptcy continues to hover over the market with its potentially game-changing legal implications.

Armed with Governor Snyder’s renewed support, Detroit Emergency Manager Kevyn Orr is not backing away from his “scorched earth” strategy with respect to the city’s creditors. His latest target? Insurance company Syncora. Syncora is in the awkward position of having guaranteed both the most “secured” of the city’s debt, i.e. some of its interest rate swaps, and the least “secured” – i.e., some of the Pension Obligation Bonds (POBs). While we can’t really discuss all the legal maneuverings here, the insurer is apparently trying to tie its secured position to its unsecured exposure by blocking the release of city casino revenues securing the swaps. Mr. Orr is suing Syncora for obstructing and potentially undermining ongoing negotiations with all the secured creditors.

Even the city’s water & sewer debt may not be spared after all. Before the holiday, S&P lowered the system’s ratings to BB- with a negative credit watch on concerns that even this historically “protected” revenue debt may be subject to restructuring.

One thing we know for sure: when the restructuring of Motown’s debt is completed, either in or out of bankruptcy, not many of the muni market’s legal “sacred cows” will remain unchallenged.

The State of Michigan’s rather relaxed attitude toward the financial condition of its local units (and toward bondholder protection) may be impacting its cost of capital. Detroit notwithstanding, many of its school districts are also in precarious financial condition: The Bond Buyer reports that Michigan had 49 school districts with general fund deficits at the end of June 2012.  Three school districts currently are under state control: Detroit Public Schools, the School District of Highland Park, and Muskegon Heights Public Schools. Two more districts defaulted back in May: Pontiac School District and Buena Vista School District. Is it any wonder that, as we start this new quarter, Michigan still figures prominently among the ten muni debt issuers with the widest spreads for 10-year bonds versus the MMD AAA benchmark? Until the State starts to take its bondholders’ interests to heart, even a resurgent U.S. auto industry won’t help improve the market’s perception of its debt.

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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