Market Outlook

Over the past two sessions, the Treasury market has been drawing support from a disappointing August payrolls number and from the flight-to-quality bid related to the potential U.S. strike on Syria. This morning, the Russian government has apparently stolen President Obama’s thunder by getting Syria to agree to a proposal to relinquish control of its chemical weapon arsenal. With the fear factor subsiding, Treasury yields are starting to move back up as traders position themselves for this week’s auction. At this writing, the 10-year and 30-year Treasury yields are hovering around 2.96% and 3.89%, respectively.

The municipal market has also benefited from the firmer tone in Treasuries, with tax-exempt yields dropping by a couple of basis points yesterday. However, traders are showing little conviction as the new issue supply starts to build again and the specter of Puerto Rico continues to hang over the market.

New Issue Market

Just under $6 billion in new issues are expected to be priced this week, a sharp increase from last week’s anemic $1.4 billion. The negotiated side will see about $3.8 billion, with most deals in the $250-300 million range, with the exception of a $385 million Miami-Dade Seaport Revenue issue (the latter will be used to enhance the Port of Miami’s facilities in anticipation of the 2015 expansion of the Panama Canal).

In the case of Puerto Rico, selling seems to beget more selling.

The competitive calendar should total around $2.10 billion, anchored by $758 million for AAA-rated New York State Personal Income Tax Revenue issue. Assuming a reasonably stable Treasury market, most of these deals should find a home this week.

The Pressure on Puerto Rico Intensifies

In the case of Puerto Rico, selling seems to beget more selling. First, retail investors were the ones spooked by media reports about the excessive exposure certain mutual funds have to PR paper. Perhaps in response to shareholder concern, some major institutional investors are also panicking out of PR names.

Yesterday, a major Boston-based mutual fund put out for the bid a sizeable block of PR G.O.s 6 ½% of 7/1/2040 (74514lwx1) and traded them into a 10.08% bid (+568 to the MMD AAA curve). Yes, you read that right, double-digit triple tax-exempt yields. These are the same bonds that would have traded around 8.50% just a week ago.

In the absence of new credit news, the double-digit yield threshold should probably hold for now. Some of the G.O.s have already re-traded into a stronger bid of 9.70%, not quite as shocking as 10.08% but still quite lofty.

Perhaps even more important than the eye-popping yield levels, the dollar price on many PR bonds is now at levels that more closely track their potential recovery values. For a distressed investor, buying a G.O. bond at a price in the 60-cents-on-the-dollar range may greatly reduce any potential downside in the event of a debt restructuring or default. For instance, the PR G.O.s that traded yesterday fetched a dollar price of only 67, whereas they were marked around 110 at the beginning of the year.

Now more than ever, the Padilla Administration needs to adhere to the soundest practices of disclosure and transparency to avoid being shut out of the market.

In a sense, the market may be sending the message that PR’s debt load cannot be supported by its economy and will have to be restructured. For that reason, investors should start taking dollar price into account as opposed to raw yield when considering PR paper, unless the bonds are enhanced by a still-solvent bond insurer. It will be interesting to see if this new focus on dollar price will lead to an inversion of the yield curve for PR, as investors may require higher yield levels for shorter versus longer-term maturities in order to achieve the same dollar price.

The latest selloff in PR paper may be partially attributable to the Commonwealth’s recent private placement of $1.4 billion in new debt: $400 million notes for the Highway and Transportation Authority and another $1 billion in assorted bond, tax and revenue anticipation notes. All this paper was reportedly taken down by various banks in the continental U.S. as well as in PR, including Barclay’s. The interest rate on this privately-placed debt is based on LIBOR plus a spread that escalates sharply the longer the notes remain outstanding. For instance, the initial spread of +240 basis points off LIBOR on the Highway notes will rise to +565 if the notes have not been retired by month 13 and eventually to a huge +1140 basis points beginning in month 18. The intent, of course, is to force the borrower to refinance the notes as soon as possible.

Were these transactions disclosed on a timely basis on EMMA? Not at all. Were it not for the diligent efforts of certain members of the financial press, the average investor wouldn’t have found out about this critical development until much later. Clearly, this is not the way to make investors more comfortable about buying your bonds.

By resorting to private placements, the Commonwealth basically admitted it currently has no access to the long-term capital market, or at least no access at politically acceptable interest rate levels. In fact, these short-term transactions may raise, not reduce, the potential refinancing risk already facing this credit. Yet, the interim head of the GDB claims the recent note sale shows market acceptance. Go figure.

Faced with its new, almost usurious cost-of-capital, the GDB announced this morning it will scale back its financing plans for the rest of the year. Its projected bond sales will now range between $500 million to $1.2 billion. Of course, the longer PR delays its fixed-rate long-term financings, the greater the yield penalty it will pay under the terms of its privately-placed short term debt. So, really, there is no escape from the market verdict.

Now more than ever, the Padilla Administration needs to adhere to the soundest practices of disclosure and transparency to avoid being shut out of the market. A good first step would be to release its much-delayed and overdue 2012 Comprehensive Annual Financial Report (CAFR) as soon as possible.

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