Market Outlook
The dog days of summer are upon us and the Treasury market appears to be stuck in a five basis points or so trading range after this week’s relatively uneventful auction. The benchmark 10-year and 30-year yields closed at 2.59% and 3.67% last night.
In the municipal market, much has been made in the media about the potential fallout on all Michigan issuers from the Detroit bankruptcy. Saginaw County was the latest casualty this week, as it was forced to pull a $61 million taxable LT G.O. pension obligation issue to avoid paying an exorbitant yield penalty. This Aa3-rated issuer found no taker for its 20 year maturity, even at a proposed +200 spread over 30-year Treasuries (at +200, we estimate the yield penalty to be at least 100 basis points).
Of course, it’s much easier to act like a discriminating buyer when you don’t have any money to spend. After 11 weeks of consecutive outflows, the mutual funds can point to this week’s reduced redemptions as a moral victory of sorts. According to Lipper, weekly reporting muni bond funds experienced $974 million in outflows from for the week of Aug. 7, down sharply from $2.24 billion the previous week. Long-term muni funds accounted for $880 million of the outflows, high-yield funds for $209 million.
The lack of cash certainly didn’t deter those buyers who couldn’t resist the lure of a 7.00% yield on the latest PREPA deal. The latter was reasonably well-received on Wednesday, allowing the underwriters to lower the scale by a very nominal three basis points. Now, the question is: how are these new proud owners of PREPA bonds going to pay for their purchases? What would they sell on the back end of this trade? Would this put some pressure on the secondary market?
Is the Unlimited Tax G.O. Pledge a Relic of the Past?
Call it the Detroit paradox: the decades-long socio-economic decline that culminated in the Motor City’s bankruptcy filing is quite unique in its magnitude. Yet, Detroit’s Chapter 9 has also brought to the fore some universal issues that are likely to affect the entire muni market for years to come.
In most states, a G.O. pledge that’s enhanced with a special revenue pledge will also be relatively bankruptcy-proof.
One of those key issues, as discussed ad nauseam in the financial media, is the City’s attempt to include its Unlimited Tax G.O. bonds in the “unsecured” creditor class. Muni investors have always operated under the assumption that the unlimited tax, full faith and credit pledge is the strongest security one can possibly obtain. Imagine their dismay when they found out that just the opposite may be true if Detroit gets its way: instead of being at the top of a municipal entity’s capital structure, UT G.O. bonds may end up at the bottom if their security is deemed to be a residual claim on municipal resources after all other claims with more specific revenue pledges are satisfied. Furthermore, G.O. debt may end up in the same unsecured creditor class as pension liabilities. If the latter turn out to be constitutionally-protected at the state level, then G.O. bondholders will truly end up at the end of the line.
Looking past the howls of outrage from muni market pundits, it turns out the G.O. pledge was never all that clear-cut in the first place. It’s just that, over decades of tradition and customary practices, muni investors have conveniently chosen to ignore the intricate interplay of state and local tax and debt statutes that underlie any G.O. pledge.
Legal experts, such as Jim Spiotto from Chapman & Cutler, have been pointing out for years that, when it comes to G.O. bonds, the “devil is always in the details and the disclosure.” For instance, most states have constitutional or statutory tax or debt limitations, which would effectively constrain any “unlimited tax” pledge. Some states set a specific priority in their constitution or legislation for the payment of G.O. debt. Other states reserve for themselves the full power to tax, and municipal entities within those states must be specifically authorized to tax. Other state-to-state variations include mandated appropriation requirements and set-asides for G.O. debt service.
While this is not intended as legal advice, it’s our understanding that the pure UT G.O. pledge may be viewed as strongest in states that effectively “secure” all G.O. debt with a so-called statutory lien. This statutory lien allows the debt to be relatively unaffected by Chapter 9 proceedings. In case you’re wondering, five states currently have such a statutory lien: California, Colorado, Florida, Louisiana and Rhode Island.
In most states, a G.O. pledge that’s enhanced with a special revenue pledge will also be relatively bankruptcy-proof.
At the risk of waxing philosophical, the unlimited tax pledge was probably the product of more bountiful economic times, when housing and property values could only go up and when debt levels were more manageable. Furthermore, the UT pledge was generally restricted to voter-approved debt, so there was implicit political support for repayment of the debt at all costs.
However, as the nation’s population aged and the number of retirees within municipal retirement systems grew in relation to the active work force, pension and OPEB liabilities have become a new source of non-voter approved debt. Politicians have also been back-loading municipal cost structures by granting municipal workers richer benefits instead of salary increases. We have now come to the point where annual pension expenses have grown enough to compete with cities’ operating expenses and the combined weight of bonded debt service and pension costs are starting to crush many a municipal budget.
So, to answer our own (admittedly provocative) question, you can still rely on the UT G.O. pledge, as long as you pay attention to each state’s statutory environment. Moreover, you certainly don’t want to test it with lower-rated local credits. Once you get into Chapter 9, regardless of how strong you think your security position is, all bets are off.
The end of the bond insurance era has shocked muni investors out of their complacency and forced them to pay attention to credit research again. Now, the issues raised by Detroit should force municipal analysts to really do their homework and learn about capital structure like their corporate counterparts. We would view that as a positive development for the industry.
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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