Just when we thought 10-year Treasuries had found some degree of support around the 2.50% level, fresh new supply and hints of economic stabilization in Europe have brought on renewed weakness this week. Traders are also starting to focus on the July employment data due out next week. The 10-year and 30-year bonds closed last night at 2.61% and 3.65%, respectively.
With Detroit (and, to some extent, Chicago) constantly in the headlines last week, continuing outflows from weekly reporting muni funds were to be expected: another $1.23 billion for the week ended July 24th, according to Thomson Reuters.
After tax-exempt bond prices reached a temporary bottom around the end of June, we had speculated that the market could go back and retest the recent high in yields. This did in fact occur: the weekly average yield to maturity of the Bond Buyer Municipal Bond Index has risen 21 basis points to 5.10% for the week ending July 25, 2013. This is the highest weekly average for the yield since the week ended Aug. 4, 2011 (103 weeks ago), when it was 5.13%.
Fortunately, the market appears to have caught a bid late Thursday and the tone is reportedly much improved this morning as we head into the weekend.
As you may have heard, the first major legal hurdle standing in the way of Detroit’s attempt to file Chapter 9 has been resolved, and it dealt primarily with “jurisdiction": on one side, we have the Tenth Amendment and state constitutional protections; on the other, federal bankruptcy law.
U.S. Bankruptcy Judge Steven Rhodes ruled on Wednesday in favor of the city’s request that it be protected from lawsuits in State courts seeking to block its bankruptcy filing. He also extended the protection to state officials, including Michigan Governor Rick Snyder and Treasurer Andy Dillon. So, for the time being, federal bankruptcy law trumps state law.
The City of Chicago’s bonds have been another indirect casualty of the Detroit fiasco, following a three- notch downgrade last Friday to A3 from Aa3 by Moody’s Investors Service.
This ruling clears the way for the real fight: whether or not the Motor City actually has the right to file for bankruptcy, a process which legal experts say could take as long as a year.
This week has seen a steady stream of Detroit-related bonds out for the bid, mostly retail size odd lots but also a few institutional blocks. For those of you who are inclined to speculate, we would point you toward the senior lien water and sewer debt, which should rank among the best-secured of the city’s related debt. Kevyn Orr himself has been on record stating he will honor the utility debt. Subject to your own investment guidelines, we believe they represent a good relative value in the high 80s (cents on the dollar), which is where they are currently trading. We would ignore any yield consideration at this point and focus primarily on obtaining an attractive dollar price.
Is Chicago Next?
The City of Chicago’s bonds have been another indirect casualty of the Detroit fiasco, following a three- notch downgrade last Friday to A3 from Aa3 by Moody’s Investors Service. The latter cited a potential sharp spike in pension liabilities over the next two years as the key reason for the downgrade. City officials blame the State’s inaction regarding pension reform: According to The Bond Buyer, “the Emanuel administration has warned that retirement contributions will cost about $1.2 billion within four years if the state legislature doesn’t restructure the system, up from $476 million last year."
While we wouldn’t give in to panic at this time, Chicago bondholders do have every reason to be on their toes.
The rising overlapping debt and pension load has also led Moody’s to downgrade other related credits such as the Chicago Board Of Education and the Chicago Park District.
To get a more objective idea of how bad the Chicago situation is, we went to Marc Joffe from Public Sector Credit Solutions. Marc, as you may recall, is the author of a recent ground-breaking study on default probabilities for California cities. We asked Marc to run both Detroit and Chicago’s financials through his open source default probability model, just to see how they compare to each other. Here’s what he came up with:
“Detroit’s default probability (DP) score is 3.34% – worse than almost every California city in our survey. Chicago’s score is also pretty bad: at 1.77%, it is worse than Stockton, one of the two California cities that defaulted in 2012.
The main driver of Detroit’s high DP score is its negative general fund balance. The ratio of Detroit’s General Fund balance to General Fund expenditures is -27%.
Although Chicago does not have a positive general fund balance, it had an annual general fund deficit and declining revenues – two of the other indicators that drive the score. The Windy City also has a relatively high ratio of interest and pension costs to total governmental fund revenue. When these uncontrollable costs become relatively high, bankruptcy is harder to avoid.”
These findings are clearly sobering. Obviously, Chicago’s socio-economic base is much more diversified and resilient than Detroit’s. However, decades of spending beyond your means will eventually catch up to you. As Phil Rosenthal, a columnist for the Chicago Tribune, cleverly put it: “No matter how much horsepower you produce, you can’t outrun math."
While we wouldn’t give in to panic at this time, Chicago bondholders do have every reason to be on their toes. On the flip side, if you’re looking at this as a potential buying opportunity, we see the +150-175 spread range as an area of relative value for the G.O.s. Not coincidentally, this is also the trading range for the State’s own bonds. As things stand currently, Chicago’s credit outlook is very much tied to Illinois’ efforts to reform its own pension system.
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