Market Outlook
It has come down to this: Day One of a federal government shutdown. The longer this latest Washington political debacle goes on, the greater the chance it will derail the nascent U.S. economic recovery.
The showdown in the nation’s capital may have a more immediate impact on the financial markets: there are rumors that the September employment report, due out this Friday, may be delayed or compromised in some fashion. Whether this may lead to further volatility in the days ahead remains to be seen. In the midst of all the political chaos and confusion, the yield on the benchmark 10-year Treasuries has retreated back to the 2.65% level.
New Issue Market
In the municipal market, a collapse in new issuance continues to be the theme. In fact, according to The Bond Buyer, “September long-term municipal bond volume fell to its lowest since 2001, when terrorist attacks on the World Trade Center and the Pentagon closed the markets for four days.”
The showdown in the nation’s capital may have a more immediate impact on the financial markets …
With all the uncertainty in Washington, this week’s primary calendar continues to be muted, with only about $4 billion in new issues scheduled to be priced. The negotiated slate offers quite a diverse mix: $899 million in senior lien revenue bonds from Chicago O’Hare Airport, $575 million in G.O.s from the State of Connecticut, $473 million in lease revenue bonds from the California State Public Works and $344 million in tobacco settlement bonds from the State of Washington.
The current price talk on these new issues raises some interesting relative value questions. The Washington tobaccos in 2033 are currently offered at about +153 off AAA. The Chicago O’Hare bonds with the same maturity are priced at +110 (non-AMT). Which of these two names is the better relative value? We’ll let you be the judge.
Can Puerto Rico Tax Its Way Out of A Recession?
Even though all Puerto Rico-related paper have sold off precipitously over the last few months, the bonds backed by a dedicated share of the Commonwealth’s sales and use tax (a.k.a. “COFINA bonds”) have held up the best in terms of yield, mainly due their relatively lofty ratings. Moody’s and Standard & Poor’s still rate the senior lien COFINA bonds Aa3 and AA-, respectively, based on their security structure. Whereas PR G.O.s are now trading with the 8.00% yield handle (after cracking the double-digit mark at the beginning of September), longer-dated senior lien COFINA bonds continue to trade with 6.00% yield handles.
So far, the Street has put a positive spin on the COFINA proposal on the basis that it does provide the Commonwealth with additional financing flexibility and may reduce refinancing risk.
Since the Commonwealth has been for all practical purposes shut out of the public market, at least in terms of G.O. financing, it has no choice but to turn to its lowest-cost means of financing. Last week, the GDB announced a proposal to amend Act 91, which governs the issuance of COFINA bonds. The proposed change would raise the percentage of the sales and use tax dedicated to COFINA from 2.75% to 3.5%, which would give PR another $2 billion in bonding capacity. The “new” debt, if and when issued, is expected to be subordinated to the existing COFINA bonds, although it is secured by the exact same revenue stream.
So far, the Street has put a positive spin on the COFINA proposal on the basis that it does provide the Commonwealth with additional financing flexibility and may reduce refinancing risk. To us, Puerto Rico’s financial team probably had no other viable option. After all, diverting more revenues from the General Fund would further restrict operating flexibility, not the other way around. Perhaps the holders of the recent short-term private placements needed some assurance they will be taken out at the appropriate time?
Yesterday, Standard & Poor’s lowered its outlook on the “COFINA” bonds to “negative” from “stable.” Interestingly, the rating service cited the Commonwealth’s shrinking economy and population as reasons for the negative outlook, not the additional leveraging of a restricted revenue source.
In fact, at the end of the day, everything does come down to the economy. And the latest economic statistics continue to look grim and are, in fact, getting worse. The August Economic Activity Index (EAI), just released by the GDB last week, showed a 5.4% year-over-year decline. Most of the components of the Index were down: total non-farm payrolls -4.4%, electric power generation -2.2% and cement sales -15.5%.
As one of our readers pointed out, the numbers look so bad the GDB had to dedicate two full pages in its report to explain why “the GDB-EAI is an indicator of the general economic activity, not a direct measurement of the real GNP,” with the EAI growth rates displaying more volatility than real GNP growth rates. The GDB report then went through a description of how the Bank uses the EAI numbers to forecast real GNP growth rates. All that sounds very reasonable until you realize that the GDB’s GNP growth forecasts have consistently overshot actual real GNP growth in every single year since 2006!
Of course, the fact remains that the economy is still contracting. Local anecdotal evidence, as reported in a recent Fox News article, further confirms that the recent round of tax and fee increases has exacerbated the already high cost-of-living for PR residents. Other reports point to a steady exodus of younger Puerto Ricans to the U.S. mainland in search of employment opportunities.
As regular readers of this column know, we’ve always given full credit to the Padilla team for taking the necessary steps to try to restore fiscal stability. However, we’ve also expressed concern about the dampening effect of the latest revenue increases on a still recessionary Puerto Rican economy. Based on the latest economic readings, it would appear that some of our fears have been realized. The island’s economy continues to buckle under the size of its government spending and its current debt load. At this point, in the absence of major economic development initiatives, it’s hard to imagine how PR can pull off the impossible feat of taxing (and borrowing) its way out of a recession.
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