Market Outlook
There’s nothing quite like ugly poll numbers to motivate politicians. Faced with unprecedented disapproval ratings from the electorate, our fearless leaders in Washington have reportedly decided to return to the negotiating table to work out at least a short-term deal to raise the debt ceiling for another six weeks. Depending on the details of the final agreement, if there is one, we could be right back to exactly the same place a few weeks from now.
… anything that would postpone the prospect of a potentially catastrophic Treasury default would be welcome news to the financial markets.
Nevertheless, anything that would postpone the prospect of a potentially catastrophic Treasury default would be welcome news to the financial markets. The stock market reacted with a strong rally yesterday, while the yield on the benchmark 10-year Treasuries remain anchored around the 2.65% level at this writing.
Even in the absence of significant supply, tax-exempt yields have nudged up by two to four basis points over the course of this week. The demand side continues to be lacking: weekly reporting muni bond funds continued to report outflows of $729 million for the week of October 9, according to the latest Lipper numbers, compared with $690 million in redemptions the previous week. Interestingly, high-yield muni bond funds saw outflows of $86 million flows after three straight weeks of inflows.
Retail Investors and the Puerto Rico Debacle
Exit Meredith Whitney, enter Kyle Bass. The same day Meredith Whitney announced she had to shut down her research service due to a lack of customers, hedge fund manager Kyle Bass of Hayman Capital opined on CNBC that Puerto Rico (PR) bonds are nothing but “junk”, worth 10-20 cents on the dollar in the event of default. So once again, we have another outsider with little experience in the municipal market making preposterous statements on a subject they clearly know little about. As cautious as we’ve been on the outlook for PR bonds, we can safely predict that the potential recovery value for the G.O. debt from a quasi-sovereign entity like the Commonwealth of PR will far exceed the numbers bandied around by Mr. Bass, assuming we even get to a restructuring at all.
Time and time again, the tax-exempt market has shown itself vulnerable to media headline risk, particularly when the demand side is lacking.
Maddeningly, as uninformed as it was, Kyle Bass’ pronouncement did put further pressure on PR bonds. Time and time again, the tax-exempt market has shown itself vulnerable to media headline risk, particularly when the demand side is lacking. Unfortunately, many of the mutual funds are not in any position to defend their PR holdings as they may already be over-exposed to the credit. Regulators are also starting to breathe down their neck: yesterday, Massachusetts Secretary of the Commonwealth William Galvin announced his securities division will begin an inquiry to determine if a handful of financial institutions have appropriately disclosed their PR exposure to their investors.
As a result, the funds can only stand by helplessly while crossover investors continue to hammer on PR debt.
For the hardy souls who have been putting their toes into the PR market, the last two weeks must have been disheartening. What was widely perceived as a relatively “safe” play among all PR credits, the highly-rated sales tax-backed COFINA bonds, has turned into a big letdown. Following the recent rating actions from Moody’s and Standard & Poor’s, COFINA bond yields have continued to rise this week, crossing into the next yield handle, in fact. For instance, the First Subordinated COFINAs 5 ¼ of 2041 we mentioned in our last column have traded down from a 7.94% yield last week to as low as 8.31% yesterday. This translates to a stunning spread of +424 off the MMD AAA scale for an A2/A+/A+ rated credit!
At this rate, by the time the Commonwealth comes to market with its third-lien COFINA issue, the market could be looking for yields close to 9.00%. No wonder the Padilla Administration has announced an investor webcast for next Tuesday, October 15th to try to stem the negative tide and highlight its fiscal achievements to date.
This all begs the question: as an individual investor, what should you be doing with your Puerto Rico exposure at this point? First, let’s be clear that our comments are of a general nature and are not meant to apply directly to your individual situation since everyone’s financial situation and degree of risk tolerance will be different. With that caveat in mind, if you currently own individual bonds, it’s too late to be a seller, unless you need liquidity for other reasons. As long as the dollar price on your bonds is around 60-70, we would argue that the risk-reward equation is now on your side. This is particularly true if you intend to hold the bonds to maturity and can tolerate some potential volatility in terms of the market value of your bonds. Remember, so far your “losses” are only on paper, so make sure you consider all the angles before actually realizing this loss.
One of the angles might be taxes. If you have significant gains elsewhere in your portfolio, perhaps on the equity side, this is the perfect time to consider a “tax swap” strategy. Check with your financial representative for details about how this might help reduce your tax liabilities for this year.
Take a close look at your PR exposure and make sure you only hold only the credits with which you feel comfortable. The market is currently lumping all PR credits together, with insufficient differentiation in yield levels between the various security structures, in our view. This should give you an opportunity to “upgrade” your PR exposure (i.e. swapping out of weaker credits into stronger credits) without giving up much yield and preserving most of your upside in the event PR recovers.
If you still have to sell your bonds, do make sure you get the best execution possible. As bad as the recent selloff has been, retail investors are the ones who have been hammered by wide bid-ask spreads on odd lots. Check where institutional size blocks are trading on the MSRB’s EMMA site and make sure the bids you receive reflect a reasonable retail/odd-lot concession.
If your exposure to Puerto Rico is primarily through your mutual fund holdings, you ought to seriously question whether your fund manager has met your expectations in terms of providing you access to a truly diversified portfolio. This will be the kind of year that differentiates the gamblers from the true investors. Your fund’s performance in the wake of the bond market selloff as well as the Puerto Rico fiasco will give you a strong indication of its investment style. Just make sure you’re fully aware of all the risks and can live with the potential volatility, if any, attendant to such an investment style.
If nothing else, the Puerto Rico situation shows that you, as an individual investor, should start taking responsibility for being informed about your investments, be they individual bonds or mutual fund shares. Luckily, there are more online tools than ever at your disposal to accomplish that, and more professional help available should you decide to go that route. Being informed will help you rationally sort through all the sensational headlines, particularly those driven by opportunistic hedge fund managers.
Questions or comments? Write us at research@axiosadvisors.com.
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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