Market Outlook
Going into the employment report this morning, the U.S. fixed-income market remains under pressure as much of the economic data released this week have exceeded market consensus. The FOMC’s decision to maintain the status quo on Wednesday did provide some temporary relief, but even that proved short-lived.
As of Thursday night, the yield on the U.S. Treasury’s 10-year note has risen by 13 basis points this week, to 2.72%, its highest level since July 28, 2011. The yield on the Treasury’s 30-year bond also surged 11 basis points this week, to 3.77%, its highest level since Aug. 11, 2011 (103 weeks ago).
At the risk of sounding like a broken record, demand for tax-exempt paper has yet to improve.
Of course, with market participants already anticipating the worst, we may well be set up for a relief rally, regardless of the actual payrolls number.
Municipals have actually outperformed Treasuries on the downside this week, but primarily due to a lack of supply. At the risk of sounding like a broken record, demand for tax-exempt paper has yet to improve. In fact, municipal bond funds endured the second heaviest outflows of the year this past week: investors withdrew $2.24 billion from weekly reporting muni bond funds during the week ended July 31st, according to Lipper. That compares with outflows of $1.23 billion for the week ended July 24th. Long-term muni funds lost $1.69 billion while high yield muni funds saw outflows of $580 million. And to think that fund shareholders haven’t even seen their July statement yet!
Puerto Rico Returns to the Market
As we mentioned in our last column, the Commonwealth of Puerto Rico will be returning to the market for the first time this year with what is generally perceived as its strongest credit, the Puerto Rico Electric Power Authority (PREPA). Next week’s $600 million PREPA deal will also be the first major issue since the Padilla Administration took over and should be a good test of investor tolerance for marginal credits in the wake of the Detroit fiasco.
Already, one of the major financial news services has proclaimed the “Worst Over for Puerto Rico.” However, the evidence for such a rebound is decidedly mixed. Year-to-date, spreads for PR G.O.s have indeed tightened modestly, but only on the long end, and they have in fact widened in the intermediate range. As of July 30th, according to Municipal Market Data (MMD), the spread for the 30-year range closed at +245bps versus the MMD AAA GO spot rate, compared to +275bps in early January. However, in the 10-year range, the Commonwealth’s G.O. bonds closed at +320 basis points, having started out the year at +290.
Next week’s $600 million PREPA deal will also be the first major issue since the Padilla Administration took over and should be a good test of investor tolerance for marginal credits in the wake of the Detroit fiasco.
Although we do give the Padilla Administration much credit for addressing head-on many of the fiscal issues it had inherited, the island’s fundamental economic outlook has yet to improve. In fact, while the U.S. economy appears to be on the mend, the PR economy continues to head in the opposite direction. The June Economic Activity Index released by the GDB just last week showed a 4.5% year-over-year decline. All the components of the Index, with the exception of gasoline consumption, took a dive: non-farm payrolls and electric power generation declined by 3.4% and 9.1%, respectively. It is conceivable that recent austerity budget measures and various tax increases designed to address the fiscal deficit may have had a dampening effect on economic activities, at least in the short term.
From a disclosure standpoint, the Commonwealth is no poster child either. Thus far, it has twice delayed releasing its FY12 audited financial statements and we apparently won’t get to see its 2012 Comprehensive Annual Financial Report (CAFR) until September.
Puerto Rico’s political status is also back in the news, adding another potential source of uncertainty. The Senate Committee on Energy and Natural Resources held a hearing on July 31st regarding plans for a new plebiscite on the subject of statehood. A referendum last November in which a majority of Puerto Ricans apparently voted against continuing the island’s current territorial status has been severely criticized for its ambiguous and potentially misleading wording.
According to The Bond Buyer, the Puerto Rico legislature will be in charge of crafting the wording for the upcoming plebiscite. Perhaps this time around, the legislators could point out to their voters the potential loss of the triple tax-exemption under the statehood scenario. Without such advantaged tax treatment, PR runs the real risk of seeing its cost of capital shoot up, as it will have to compete with the other 50 states on a more level playing field.
Returning to the specifics of the upcoming PREPA issue, we had a chance to review the roadshow presentation and took note of some interesting credit facts.
First, from an operational standpoint, the obvious knock on this massive system with 1.5 million customers (on a par with LADWP) is its heavy dependence on oil for 61% of its generation, with only 21% coming from natural gas. The Authority has embarked on an aggressive fuel diversification program with the goal of reducing oil dependency to a mere 10% by 2018, with natural gas ultimately accounting for 70% of the fuel mix. This necessary but expensive endeavor will depress debt service coverage for the foreseeable future: the Authority is forecasting coverage in the 1.32x range by FY2018, down from the already slim 1.38x level in FY2014.
Furthermore, Puerto Rico’s utilities are notorious for their weak revenue collections and high delinquencies. It turns out the major deadbeat accounts are the Commonwealth’s own agencies. For 2013, PREPA’s past due receivables included an astonishing $48 million from the central government and $197 million from public authorities. Furthermore, certain municipal entities have been enjoying free power from PREPA as Contributions In Lieu Of Taxes (CILTs). Under new legislation passed in 2011, many of these entities have now been identified as revenue-producing enterprises that should be paying for their own electricity. PREPA stands to collect as much as $49 million per year from this “new” source through FY2018.
Lastly, it’s still not clear to us PREPA should be viewed as a stand-alone credit, given the obvious inter-dependency among all the Commonwealth’s agencies. The market certainly doesn’t make that much of a distinction, given the current spread compression among all PR agency names. One thing is sure: the credit outlook over the next few years will remain marginal at best.
(Note: This is, of course, not meant to be a comprehensive review of the PREPA credit. To order a full report, please contact us at research@axiosadvisors.com).
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