Market Outlook
One week into the Federal government shutdown, the fixed-income markets appear to be taking all the uncertainty in stride, although their patience may start to fray the closer we get to the dreaded October 17th debt ceiling deadline. With many key economic reports cancelled or delayed by the shutdown, including the critical September employment data, traders are, to some extent, flying blind. For now, the yield on the benchmark 10-year Treasuries has remained locked in a 2.60-2.65% range, although this trading range may be challenged by this week’s fresh Treasury supply. Ironically, long Treasuries are probably the only financial instruments in the universe whose price will increase the higher the probability they will go into default!
At the macro level, a protracted budget debate would push the timing of any potential Fed taper into 2014 at the earliest. This would imply a fairly benign interest rate environment through year end, which should benefit high grade municipals.
It’s fair to say that a failure to raise the debt ceiling on October 17th would have a greater impact on munis than the current government shutdown. Certain sectors that are dependent on federal funding – namely education, transportation, housing and health care – will certainly be affected. In our view, health care would be the area of greatest concern as the sector is already struggling with the potential impact of Obamacare. Lower-rated hospitals with weak liquidity and a high Medicaid/Medicare burden may be severely affected. Since the impact will be credit-specific, any wholesale selloff or spread widening in this sector should provide opportunities for discerning investors. That said, health care investors appear to be quite complacent at this time; according to Barclays, hospitals are currently the second tightest-trading sector, after housing, as measured by its current Option-Adjusted Spread (OAS) compared to its 180 business day mean OAS.
With many key economic reports cancelled or delayed by the shutdown, including the critical September employment data, traders are, to some extent, flying blind.
Between the events in Washington and the resumption of outflows from the mutual funds, muni market participants have every reason to stay on the sidelines for the time being.
New Issue Market
With tax-exempt yields basically flat for the last few days, the new issue calendar is expected to pick up this week to $3.76 billion, up from last week’s revised $2.77 billion, but still quite modest by historical standards. Much of the new supply will be negotiated, with a $594 million G.O. offering from the State of Wisconsin, a $434 million revenue issue from Broward County, Florida Airport and a $406 million Highway User Tax Revenue offering from the State of Oregon. We find it interesting that a high quality State G.O. issuer like Wisconsin chose to take the negotiated route, instead of going competitive.
Puerto Rico Update
At this point, the Padilla Administration must feel it’s getting blocked at every turn by “the market.” As soon as it has found a cheaper way to access the market, i.e., through its sales and use tax bonds, the rating agencies came out and put a wrench into it. First, Standard & Poor’s revised the outlook on COFINA to “negative,” citing the Island’s floundering economy. Then last Thursday, Moody’s downgraded the Senior Lien COFINA bonds from Aa3 to A2, with a “negative outlook” to boot. In Moody’s case, the agency’s rating on the Senior Lien bonds have long been too high relative to the G.O. rating, so it was arguably more of an adjustment than an actual downgrade.
Over the next few weeks, it’s fair to assume there will be a concerted effort by the Commonwealth and the Obama Administration to “talk up” the outlook for Puerto Rico’s economy.
As a result of the rating agencies’ moves, yield levels on all COFINA bonds have spiked up by about 40 basis points. The first subordinated bonds in particular (5 ¼ ’2041) traded down on Friday to a 7.94% yield or +390 versus AAA. This means the third-lien bonds that PR is planning to issue will have to be priced well into the 8.00% range. That would negate any potential interest cost savings to the Commonwealth, compared to current yield levels on the G.O.s.
Last Thursday, The Bond Buyer reported that the Obama administration has been monitoring the Puerto Rico and its potential impact on the tax-exempt market at large. This has, of course, led to speculation about a potential federal bailout scenario. Not surprisingly, the news was largely greeted with skepticism by the market and barely caused a ripple in trading levels. Given the current mood in Washington and the recent handling of the Detroit bankruptcy, any direct bailout scenario seems far-fetched to us at this time. We speculate the Feds may try to provide some short-term cash flow help to Puerto Rico by accelerating or moving forward certain payments due the Commonwealth, in the same manner they tried to help Detroit by “unlocking” some $300 million in various urban renewal grants.
Over the next few weeks, it’s fair to assume there will be a concerted effort by the Commonwealth and the Obama Administration to “talk up” the outlook for Puerto Rico’s economy.
At a meeting hosted yesterday by the Municipal Analysts Group of New York (MAGNY), Puerto Rico Senate President Eduardo Bhatia announced that the Boston Consulting Group will present a few proposals for Puerto Rican economic development next week. Not to be outdone, a White House task force is also expected to release an economic development proposal for the island shortly.
Up until now, we’ve been in the camp of those favoring PREPA as one of the “better” PR credits, for the simple reason that it is an essential monopoly and is somewhat financially self-sufficient, unlike PRASA. However, we’re disturbed by rising calls from local public officials for a “restructuring” of the utility, which residents blame for the high costs of electricity on the island.
At yesterday’s MAGNY meeting, State Senator Bhatia confirmed the government is considering a “major reform” effort of PREPA. Although the reform will “respect PREPA’s commitments to its bond holders and will not involve privatization,” it may involve creating a more competitive PR energy industry. If PREPA can hardly function as a monopoly currently, imagine what would happen if it were forced to compete in the open market? Clearly, this is an issue for bondholders to monitor going forward.
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