Market Outlook
The potential U.S. strike against Syria has done what two weeks of Egyptian political turmoil failed to accomplish: bring the flight-to-quality bid back to the Treasury market. After testing two-year highs last week, the yields on the 10-year and 30-year Treasury bonds have now retreated back to the 2.70% and 3.70%, respectively, a retracement of almost 20 basis points.
Although this positive tone will undoubtedly help this week’s government bond auction, the rally may prove short-lived once market players return from the Labor Day weekend and position themselves for the August employment report.
After underperforming Treasuries again last week, the tax-exempt market appears to have found some degree of stability over the last two days, with yield levels firming up by a couple of basis points. However, negative mutual fund flows continue to stymie market activities as institutional bid-wanted lists continue to surface. It will be interesting to see if outflows will accelerate further in response to Barron’s recent headline article about Puerto Rico’s credit woes, which we will discuss a bit later.
New Issue Market
With tax-exempt yields finally stabilizing, this week’s calendar is surprisingly busy for a pre-holiday week, with just about $5 billion on the docket.
A $764 million State of California G.O. will be the headline deal on the competitive side. As we discussed in previous articles, California paper is currently benefiting from a “virtuous cycle” whereby the tax increases passed last year have improved the State’s fiscal outlook while simultaneously enhancing the attractiveness of state tax-exempt bonds. Of course, while economic conditions have been improving in the Golden State, nothing has been done to date to mitigate the inherent cyclicality of the Golden State’s revenue structure.
On the negotiated side, the anchor issues will be $655 million from the New York City Housing Development Corp. and $420 million from Miami-Dade County Seaport. Both are non-controversial issues that should have no problem finding a home.
One of the more interesting issues on the calendar will be the $249 million offering for Guam’s A.B. Won Pat Airport, rated Baa2/BBB/NR and expected to price tomorrow. We would expect bonds from Guam and other U.S. territories to attract demand from investors (mostly state-specific funds) who need the triple tax-exemption but are currently staying away from Puerto Rico due to perceived headline risk.
The biggest credit knock against Guam is its total dependence on geo-political factors outside its control: the Japanese tourist trade, which depends on dollar-yen exchange rates; extreme weather conditions including typhoons; and the strategic US military presence. Lately, those factors have been going in its favor. The US is expected to move up to 5,000 Marines from its Okinawa base to Guam, as part of a realignment of its military presence in Asia. The Pentagon is deploying the Terminal High Altitude Area Defense missile system on the island in response to North Korea’s recent threats to fire missiles at U.S. bases such as Okinawa and Guam.
Away from the military presence, tourism has also been on an uptrend. In addition to the traditional base of Chinese and Korean visitors, Guam is now attracting visitors from Russia and China also. Guam’s 1.31 million visitors last year represented a 12.8% increase from 2011, coming on the heels of a 9.2% increase from 2010 to 2011. The trend has remained positive so far this year, according to local sources.
The airport’s monopoly position as the island’s only commercial facility and continued growth in signatory airlines are other positive credit factors. However, we note that enplanements have been quite volatile in recent years as a result of such events as the earthquake in Japan, the SARS outbreak, etc..
Structure-wise, the Won Pat Airport issue will consist of two non-AMT Series A and B, and a $200 million Series C subject to the AMT. Within the Series C, the pricing of the two longer term maturities will give buyers the option of going with or without Assured Guaranty, for a yield differential of 25-27 basis points. For instance, the 2034 term bonds, our preferred maturity, will be priced at 6 ¼% to yield 6.47% without insurance and 6.00% to yield 6.20% with insurance. For this kind of potentially volatile credit, we would be inclined to give up 27 basis points in yield and go with insurance.
What Munis Don’t Need Right Now: More Headline Risk
Many of you may have seen the title “Puerto Rico in Trouble” plastered on the cover of this week’s Barron’s. The lead article from Andrew Bary does a good job of summarizing all the current credit issues surrounding Puerto Rico (PR) bonds but offers precious new information to anyone but the most casual muni investor. Regular readers of this column certainly would not be surprised by anything in the article, since Puerto Rico has been a favorite topic of ours since May.
At the end of the day, let’s face it: a concentration in excess of 25% in any single sector, let alone any single credit, is never prudent, regardless of how strongly one feels about the credit outlook.
Having said that, the article may still shock some mutual fund shareholders by pointing out the degree of exposure some of the funds have to PR credits. In particular, the mutual funds dedicated to relatively small states with limited supply (e.g., Maryland) have had to rely heavily on triple tax-exempt paper from Puerto Rico, Guam and other US territories to meet their investment objectives. Of course, if the managers of such funds cannot find adequate in-state supply to get fully invested, the “right thing” to do should’ve been to close the funds to new investors. That, however, is not how the fund industry works and, as a result, we end up with Puerto Rico exposures as high as 37% in some funds.
Such concentrated exposures to a marginal credit are the reason why many market observers fret about the potential “systemic risk” posed by Puerto Rico. Those concerns peaked in the fourth quarter of last year in the aftermath of the local gubernatorial election, with Puerto Rico G.O. spreads widening to as much as 300 basis points over AAA. During the first two quarters of this year, PR bondholders were encouraged by positive moves from the new Padilla Administration to address many of the fiscal issues. However, since the start of the bond market selloff in June and the recent publicity about Detroit, muni investors are once again anxiously eying their PR holdings. With secondary market yields on all PR bonds, except for the highest-rated COFINA, now topping 7.00%, there is renewed concern about the Commonwealth’s cost-of-capital and its potential “refinancing risk.”
The Barron’s piece also brought up another legitimate issue, in our view: risk management. In the tax-exempt market, very few tools are available to institutional investors to hedge or manage their aggregate credit risk, aside from maintaining a large research staff. Portfolio diversification is one of the most basic tools that are available. Yet, many portfolio managers, under constant pressure to deliver yield, try to circumvent concentration rules by artfully redefining what constitutes a single issuer or “credit.” Puerto Rico is actually a good example of this: there used to be a time when one could at least argue (maybe not convincingly) that PRASA, PREPA and PR G.O.s are distinct credits. It is a much harder argument to make nowadays and traders are in fact treating them as the same entity in the secondary market.
At the end of the day, let’s face it: a concentration in excess of 25% in any single sector, let alone any single credit, is never prudent, regardless of how strongly one feels about the credit outlook.
Already besieged with massive outflows, the muni fund industry can ill afford this kind of headline risk at this time.
[Note: Muni Bond Insights will not be published on Friday 8/30 and Tuesday 9/3, in observance of the Labor Day holiday. We’ll see you back here on 9/6 with fresh perspectives on current muni market events.]
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